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D on:

ue i 1. tgence

Due Diligence

The Critical Stage in Mergers and Acquisitions



© Peter Howson 2003

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form Or by any means, electronic, mechanical, photocopying, recording Or otherwise without the prior permission of the publisher.

Published by

Gower Publishing Limited Gower House

Croft Road


Hants GUll 3 HR England

Gower Publishing Company Suite 420, 10 1 Cherry Street Burlington VT 05401-4405 USA

Peter Howson has asserted his right under the Copyrigh r. Designs and Patents Act, 1988, to be identified as the author of this work.

British Library Cataloguing in Publication Data Howson, Peter, 1957-

Due diligence: the critical stage in acquisitions and mergers 1. Consolidation and merger of corporations - Law and legislation - Great Britain

I. Title

346.1 '06626

ISBN 0 566 08524 0

Library of Congress Cataloging-in-Publication Da ta Howson, Peter, 1957-

Due diligence: the critical stage in mergers and acquisitions I Peter Howson.


ISBN 0-566-08524-0 (alk. paper)

1. Consolidation and merger of corporations-Great Britain-Management. 2. Consolidation and merger of corporations-Law and legislation-Great Bri tain. I. Title.

HD2746.55.G7 H69 2003 658.1 '6-dc21


Typeset in 9 point Stone Serif by IML Typographers, Blrkenhead, Merseyside and printed in Great Britain by MPG Books Limited, Bodmin


List of tables List of figures Preface

vii ix xi

1 Introduction

2 How to structure a due diligence programme 3 Working with advisers

4 Financial due diligence

5 Legal due diligence

6 Commercial due diligence

7 Human Resources due diligence 8 Management due diligence

9 Pensions due diligence

10 Tax due diligence

11 Environmental due diligence

12 IT & production technology due diligence 13 Technology due diligence

14 Intellectual property due diligence 15 Antitrust due diligence

16 Insurance and risk management due diligence

1 14 30 45 68 77

105 125 141 148 165 178 186 191 201 213

Appendix A


Al Purchaser pre-deal due diligence checklists A2 Information to be requested from the target A3 Briefing checklist

A4 Financial due diligence checklist AS Legal due diligence checklist

A6 Commercia] due diligence checklist

A 7 Human Resources due diligence checklist AS Management due diligence checklist

A9 Pensions due diligence checklist

A10 Taxation due diligence checklist

All Environmental due diligence checklist A 12 IT due diligence checklist

A 13 Technical due diligence checklist A 14 Intellectual property checklist

217 220 234 236 239 243 245 247 248 249 251 252 253 256

vi Contents

Appendix B


B 1 Financial due diligence - an example of breaking down the numbers B2 Human Resources legislation

B3 Commonly sought management competencies B4 Myers-Briggs Type Indicators®

85 UK Sources for environmental due diligence 86 Intellectual property rights

259 265 266 268 270 272

Notes Index

275 281

List of tables

1.1 The main due diligence topics

1.2 The other due diligence disciplines 2.1 The different types of M&A

4.1 The differences between audit and financial due diligence 4.2 An example of a business overview

4.3 P&L manipulations and other traps for the unwary 4.4 The reasons why stock values could be wrong

6.1 The headings for a commercial due diligence exercise

6.2 The commercial due diligence focus will vary with the type of deal 6.3 An example of the output of a KPCs interview

7.1 Miles's and Snow's characterization of culture

7.2 Handy's characterization of culture

7.3 A share sale v. a TUPE transfer

10.1 Profiling the tax risk in target companies

15.1 Differences between European and US merger regulation Al Identify action to be taken for key managers and key groups B 1 Summary profit and loss accoun t

B2 Summary profit and loss account

B3 Analysis of marketing overheads

B4 Analysis of special promotions

B5 Overrider analysis

B6 Recurring marketing costs B7 Sales adjustment

B8 Non-recurring and exceptional items B9 Summary of profit adjustments

BI0 Summary profit and 10$s account

B 11 Summary P& L forecas ts

B 12 Operating profit bridge - historic B 13 Opera ring profit bridge - forecast B 14 MBTI® indicators

8 9 16 49 54 60 63 81 83 9S

116 117 119 152 206 247 259 259 260 260 260 261 261 261 262 262 263 263 264 268

List of figures

1. 1 The acquisition process

1.2 Pre-deal activities and the increased chances of deal success 6.1 The deal evaluation process

6.2 The components of profit

6.3 The trade-off between cost savings and sales growth 7.1 Pre-deal activities and success

8.1 jungs personality types

8.2 Team dynamics

8.3 Competency profile

8. 4 Assessment of the managernen t team

12.1 Typical subject headings for an IT due diligence audit

2 5 77 79 80

106 132 134 138 138 180


This book is intended to be a practical, hands-on guide to the much misunderstood discipline of due diligence in M&A transactions. It is intended to be comprehensive, easy to read and, for a change, not slanted exclusively either towards the legal aspects or written from the adviser's perspective. However, buyers contemplating an acquisition would be well advised to take appropriate professional advice and not rely on this book to complete a transaction.

CHAPTER 1 Introduction

Who is this book for?

Due diligence is variously described as boring, expensive or time consuming and, more often than not, all three. To many it is a way of spending a lot of money to tell you what you already know. It is also incredibly time pressured. Sellers have absolutely nothing to gain by giving a buyer time to probe and question. The buyer, on the other hand, has to gather and digest an awful lot of information on a whole range of quite specialist topics in a very short time and often with less than perfect access to the sources of information. Despite what many may believe, this in practice makes due diligence not some clever financial modelling exercise or a fascinating legal challenge, but essentially an exercise in project management.

The secret is to be very focused. This book is aimed at helping the practitioner to focus.

The practitioner is the person who is going to drive the due diligence process. By knowing what information is needed, where and how to get it, and how the various due diligence professionals, lawyers and accountants as well as management consultants, go about their work, due diligence becomes more manageable, much more fun and much more costeffective. It allows acquirers to focus on what is important and therefore to make better decisions.

The book should also be helpful to the professional adviser. Even experienced advisers may find something new in the sections which follow covering disctplines other than their own. Advisers tend, unfortunately, to work exclusively on their own area of investigation without reference to any of the other advisers. Although one of the aims of this book is to change that, it is nonetheless true that even lawyers with many deals to their credit may not know much about what accountants and management consultants do and how they go about their work.

The acquisition process

Due diligence is obviously only one part of an acquisition or investment exercise. In order to understand where it fits into the overall acquisition process, let us, for convenience, assume the process falls neatly into the four generic categories shown in Figure 1.1.

Stage one is about identifying an acquisition target and making an approach. This can only sensibly be done following a proper strategic review in which acquisition has been identified as a logical strategic tool. If an approach leads on to agreement to take things further, the deal enters the second stage. The two parties sketch out the broad terms of the deal and the buyer will begin due diligence. Successful due diligence leads to negotiation and, if all goes well, the deal completes. Then the buyer enters stage four, in many ways the

2 Due Diligence

• Strategic • Heads of
review terms
• Systematic • Due
search diligence
• Approach • Sale and • Post-
purchase completion
• Completion Figure 1.1 The acq uisi lion process

most important stage of all, where the acquisition must be bedded in and made to pay its way. Each of the four stages is described in more detail below.


Strategic review

It is a long time now since Barings advised Asda not to buy MFI. Asda did the deal anyway. Barings lost a client and a big fee, Standard corporate finance 'advice' has changed a lot since then, Now advice seems to be along the lines of 'Here is a good idea: we advise you to buy this business', Acquisitions can and do happen as a result of banks hawking round ideas, They can also take place for a host of other not very good reasons, Often the chairman comes across a 'bargain', usually from one of his mates down at the golf club, Even today management may decide it would be a good idea to go on an acquisition spree to diversify shareholders' risk. Goodness knows why, when shareholders can do that better for themselves, At other times it is a case of the acquirer having a large cash pile to spend, management wanting a bigger empire, or, closely related, management persuading themselves that they can manage anything,

Acquisitions are very risky, All the academic research points to a failure rate well in excess of SO per cent, Because of the risk, acquisitions should take place only after a thorough review of strategic objectives and then only after very careful consideration of the alternatives, They should be seen as a means of achieving strategic objectives - nothing more and nothing less, They will never be an antidote to poor performance in the core business or a means of management self-aggrandizement. Acquisitions are strategic tools, a means to a strategic end and given their very high failure rate, should be seen only as a last resort,

However, strategic reviews do often identify acquisition as the most logical way forward, If the strategic review has been carried out properly then the next step will be an organized, systematic search for acquisition targets.


A systematic search for acquisitions often starts where the strategic review leaves off. The ideal targets have to be characterized. In turn this means creating a set of criteria for the types of company that should be looked at. A search will then seek to identify every company which meets those criteria, and to gather basic information about each one.

Introduction 3

The potential targets will then be ranked according to their ability to meet strategic objectives and categorized according to whether they are strong contenders for purchase or merely fallback options. More detailed information will be put together on those companies which seem to be strong contenders, and a shortlist drawn up for approach.


Acquisition targets are like London buses. None come along for ages then all of a sudden there are three to choose from. Getting from first approach to a deal can take a long time. Approaching a company can produce extreme reactions. Some potential vendors will rejoice, thinking they are about to become rich, others may be deeply offended, others say 'no' when they mean 'yes' and yet others go away only to come back again. Reactions will vary according to the target's ownership, nationality, industry, and the personalities of those involved, but if a deal is to happen at some point both parties will perceive a mutual interest and decide to take preliminary discussions further.


Heads of terms

If an approach does lead to mutual interest, both parties will want to begin serious negotiations. Heads of Agreement/Heads of Terms/Letter of Intent is the document which records an agreement to negotiate the purchase of a business. It is a non-binding agreement (see page 20) which sets out the main points on which the parties to a transaction have agreed and the basis on which they are prepared to proceed.

As far as due diligence is concerned, the critical thing about Signing Heads of Agreement is that there is a deal underway. Drawing up the document usually focuses the minds of both parties. The buyer will now have assured the seller of its seriousness, both parties will have decided that there is sufficient agreement between them to continue and both can draw comfort that the deal wi!! go ahead because they can point to a document setting out the fundamental issues. Due diligence can therefore begin.

Due diligence

As explained in greater detail below and indeed in the rest of this book, due diligence assesses the deal from a commercial, financial and legal point of view. It is concerned with understanding more about the business being bought, confirming that the buying company is getting what it thinks it is buying, unearthing any risks in the deal, finding negotiating issues and helping to plan post-deal integration.

Skeletons found in due diligence should not normally break a deal but they will be negotiating points on the way, with luck, to agreement.


Sale and purchase negotiation

With due diligence over, next comes the stage of finalizing the details of the deal. This is where everyone falls out, but eventually, after much posturing and horse-trading, negotiations are concluded, agreement is reached and the deal is signed. As mentioned above, due diligence feeds into the negotiations by identifying risks against which the buyer

4 Due Diligence

should negotiate some sort of protection. This could be through a price reduction or through a guarantee by the seller to compensate for any loss.


The due diligence is over, the terms of the deal are agreed, and completion is the process of actually signing the sale documents. For some strange reason there is an unwritten law that completion always happens at 4 o'clock in the morning, and usually at the weekend, even though all the participants struggle to avoid this!


Of course the negotiating process is highly charged and extremely challenging. Not surprisingly a satisfactory conclusion, with the new acquisition in the bag, is often seen as an end in itself. Managemen t are left exha usted and, after the thrill of the chase, too apathetic to manage the integration process.' But, to paraphrase a well-known slogan, 'a deal is for life, not just for Christmas'. Once the deal is signed, the really hard work starts: that of making the return from the new acquisition justify the price paid. In the chase and excitement of the deal this phase is often overlooked. As is discussed in some detail below, due diligence should playa major role in shaping the post-completion plan. This leads on to the next topic, what should due diligence aim to achieve?

What is due diligence?

There is no dictionary definition of due diligence. There is no standard legal definition either. A lawyer would probably define it roughly as follows:

a process of enquiry and investigation made by a prospective purchaser in order to confirm that it is buying what it thinks it is buying.

Caveat emptor (buyer beware) is central to the whole acquisition process in Anglo-Saxon countries. Due diligence is the way buyers make sure they understand exactly what they are buying.

A dealmaker might go further. A dealmaker would say that due diligence is about reducing risk. There is no shortage of surveys which show how risky acquisitions are. As already noted, according to these surveys, at least half of all acquisitions fail. The true failure figure is probably more like three-quarters. The better the due diligence, the more buyers know about a target and therefore the more they know about the immediate risks they are taking on. As far as the dealmaker is concerned, therefore, due diligence allows an acquirer to:

• identify issues which feed into price negotiations, and hence reduce the risk of paying too much:

• de-risk the deal by identifying points against which legal protection should be sought.

In other words, the dealmaker sees due diligence as an aid to working out what contractual protection is required from the vendor and what risks the purchaser should avoid completely.

Introduction 5

The problem with this thinking is that it sees the short-term issues specific to negotiations as being the same as those which in the end will dictate whether or not the deal will be a success. This may very we II not be the case.

Again, there is no shortage of surveys purporting to show where the risks in an acquisition lie. The trouble with a lot of them is that they are carried out by consultants with a post-acquisition integration consultancy service to sell. Nonetheless, it is probably true that more acquisitions fail because of shortcomings at the post-acquisition implementation stage than at the pre-acquisition investigation stage. For example, according to one piece of research2 there is an 83 per cent correlation between implementation success and overall acquisition success. Of course, this may be because pre-deal due diligence is so well carried out that risky deals never complete, but the need to think beyond pre-deal 'tyre kicking' to the post-deal aftermath is confirmed by a 1999 study by KPMG.3 As shown in Figure 1.2, this found three hard keys and three soft keys to acquisition success. The KPMG research tries to pinpoint the factors which give deals a better chance of success than average.







I I nteqraticn projectplanning

Due diligence

Selecting rnanaqernent team

Re.solving cultural issues






% Change from average

Source: KPMG

Fig ure 1.2 Pre-deal activities and the increased chances of deal success

Pre-deal synergy evaluation emerged as the main hard key to success. Acquirers who carried this out thoroughly had a 28 per cent better than average chance of overall deal success. KPMG describe this as the 'what and where' of obtaining value in a deal. Companies can only hope to avoid bad deals by working out how extra value is going to be achieved. This calls for a thorough exercise early on in the acquisition process, involving operational managers, to confirm both the robustness of synergy assumptions and their deliverability,

Integration project-planning is the next most important hard key. This is the mechanics of the 'how'. According to KPMG, the survey confirms, 'that the chances of merger success are increased if the process of working out 'how' is started well before the completion of the deal."

6 Due Diligence

The third hard key highlights the power of 'proper' due diligence. 'Proper' due diligence, according to KPMG, as used by 'sophisticated and forward looking acquirers' uses a 'springboard approach to due diligence which often uses a range of investigative tools designed to systematically assess all the facts impacting on value.' 'Value' is only created once the deal is done.

In other words, the successful acquirer's definition of what due diligence is all about goes much further than any legal or deal-doing definition. According to the successful acquirer, the objective of due diligence is not just to 'audit' or verify past performance, it is not just to look for black holes or reasons to chisel the price. It aims to do all of these but, more important for success, it should aim to assess future prospects and show how they can be realized. Of course due diligence is going to look out for vulnerabilities but at least equal importance needs to be given to identifying opportunities. After ali, there is really only one reason for buying a business. Not because it has done well in the past, nor because it is cheap. The only reason is because it has a great future with you as the new owner. As KPMG put it, 'with more money chasing fewer deals, a greater proportion of the valuation is made up of stra tegic and synergistic elemen ts'. 5

Sadly though, as the statistics show, there are few successful acquirers around. The long and the short of it is that 'acquirers keep making the same mistakes over and over again: not enough planning, too obsessed with the financials to the detriment of other areas'.6 Again this can be seen from the KPMG study where getting the soft keys right is more important to increasing the chances of deal success than getting the hard keys right.

In summary, pre-acquisition due diligence should be constructed to give as good an insight as possible into post-deal implementation as to isolating pre-deal risks. This contrasts with the quaintly traditional way in which due diligence is still mostly performed, biased towards:

• getting the deal done

• the financial and legal aspects

• unearthing 'skeleto ns'.

A proper due diligence programme, therefore, should have five strands:

• the verification of assets and liabilities

• the identification and quantification of risks

• the protection needed against such risks which will in turn feed into the negotiations

• the identification of synergy benefits (which may also feed into price negotiations)

• post-acquisition planning.

This is easy to say, but the reality is that managers working on an acquisition are first going to have to satisfy the Chairman, the board, their boss or themselves that the deal itself is under control otherwise they may very quickly find themselves working on something less high profile.

So the number one priority from due diligence is to understand what is being bought, where the immediate risks are in doing the deal and what protection is needed. But, number two, do not underestimate the benefits a well thought-through programme of due diligence can bring to the long-term success of the deal, Due diligence should be seen as integral to post-acquisition planning. In the heat of a deal, there is always a tendency to delay or play

Introduction 7

down the importance of planning for the aftermath. The evidence above would suggest that there is no substitute for early post-deal planning. The KPMG and other studies? suggest that unless there is an integration plan which is properly communicated, and the mechanics of that plan implemented within a couple of months of completion, acquirers will lose value from their acquisition. Never mind 2 + 2 '" 5; if due diligence is not used to help put together an integration plan, a buyer may well end up with 2 + 2 '" 3.

The arguments for carrying out due diligence

The above is all very well, but wha t a bout the deals where the buyer knows the com pan y very well, knows the market and quite frankly does not need to go to all the expense and trouble of due diligence? The answer is that it is possible to buy a company without doing any due diligence, but there are a few snags.

First of all, the information disclosed by the seller to qualify the warranties will be the only material formally available to the purchaser with which to confirm a decision to buy the company. Nothing at all wrong with that in certain circumstances. In addition, there will only be fairly standard warranties and indemnities available for legal protection. This is hardly surprising given that the buyer has not made the enquiries which give a basis on which to negotiate non-standard warranties and indemnities or other forms of protection. Again, this may be fine in certain circumstances. It is fairly common where the deal is quite small in relation to the size of the buyer or where the buyer's knowledge of the target is very good.

However, for reasons discussed below, just relying on warranties and indemnities is not a good idea. For a start, the protection they offer may be limited or impractical to enforce. Also if the seller is plain dishonest, which is not entirely unknown, just taking warranties and indemnities without further investigation is unlikely to uncover any fraud or other wrongdoing. Due diligence can sometimes identify suspicious activity.

Leaving aside the integration questions, the real value due diligence can add, even where buyers think they have a lot of knowledge, is in what can best be described as unearthing problems no one really knew existed. Sellers, usually quite genuinely, believe their companies to be problem-free. Often they will have lived with what outsiders would see as 'problems' without any harmful effects. This does not mean that the buyer would take the same view. However, without identifying and quantifying the 'problems', the buyer can take no view at all. For example, it is often the case that important pieces of software in early stage IT companies have been developed by programmers who are not employees of the company. The law is quite dear about copyright: it resides with the author. In this case buying the company will not buy the in tellectual property cen tral to its success. Clearly this would be an issue for the purchaser whereas for the current owners the software has been developed, it works and is selling so there is not a problem.

The second real value of due diligence is what can best be described as its comfort factor.

Everything in this universe is relative. Accountants and lawyers may be expensive, but not when compared with going to law. Comparatively speaking, due diligence is cheap, litigation is not. This is why most buyers are much more comfortable knowing about problems beforehand rather than being left with the posstbility, however remote, of making warranty or indemnity claims or having to sue the seller after completion. However good the warranties and indemnities, a buyer really does not want to litigate. Litigation is expensive,

8 Due Diligence

in both time and money, and its outcome is far from guaranteed. In fact, a buyer's aim should be never to have to open the sale and purchase agreement once it is signed.

FinaIly,knowledge is power. Due diligence gives the buyer knowledge. The more that is known about a seller's business, the better the buyer is armed, both physically and psychologically, for the negotiations which lie ahead.

Contrary to popular myth, due diligence can be a worthwhile investment.


Due diligence is not legally required. The nearest it comes to being a legal requirement is in the following circumstances:

• The Cadbury Report recommended that significant acquisitions should be reviewed by the full board of directors of the purchasing company. To ensure that the board considers all the issues, due diligence reports may be required.

• With listed companies, which are subject to the London Stock Exchange's regulations, if an acquisition is a major one and therefore needs shareholder approval, a financial report on the merged group will be required. This makes a detailed accountants' investigation necessary so that the necessary circular can be drawn up.

• In European public deals, synergy papers are increasingly becoming a critical element in pre-deal planning. In these cases the financial robustness of an acqulrer's cost savings, and in some cases their revenue enhancement targets, are vetted and approved as being realistic.

• As a defence against charges of negligence in a transaction. The US courts have found that, 'due diligence is equivalent to non-negligence'S having earlier 'established that it is not reasonable to rely on exclusively management for key data. Data must be double-checked through an independent investigation."

The different due diligence disciplines

There are a number of different types of due diligence which can be carried out. Table 1.1 summarizes the three main a rea s, while Table 1.2 shows the other usual due diligence topics. It looks like a forbidding list. In any deal, some of these will be more important than others. Some will be carried out as topics in their own right and others subsumed under other headings.

Table 1.1 The main due diligence topics

Due diligence topic Focus of enquiries

Results sought

Financial Validation of historical information, review of management and systems

Confirm underlying profit. Provide basis for valuation


Contractual agreements, problem- Warrant.ies and indemnities, validation of all

spotting existing contracts, sale and purchase agreement

Ma rket dynamics, target's competitive Sustainability of future profits, form ulation of position, target's commercial prospects strategy for the combined business, input to valuation


Introduction 9

Table 1.2 The other due diligence disciplines

Due diligence topic

Focus of enquiries

Resulis souqh;

Make-up of the workforce, terms and conditions of employment, level of commitment and mot.ivation, organizational culture

Uncovering any employment llabllltles, assessing the potential Human Resources costs and risks of doing the deal, prioritizing the HR issues that need to be dealt with during integration, assessing cultural fit, costing and planning the post-deal HR changes

Human Resources and culture


Management quality, organizational structure

I dentification of key integration issues, outline of new structure for the combined busi nesses

Various pension plans and plan valuations

Minimize the risks of underiunding


Existing tax levels, liabilities and arrangements

Avoid any unforeseen tax liabilities, opportunities to optimize position of combined business



Liabilities arising from sites and

Potential I iabilities, natu re and cost of actions

processes, compliance with regulations to limit them

Performance, ownership and adequacy Feasibility of integrating systems; associated of current systems costs. IT plans for operational efficiency and competitive advanta.ge



Performance, ownership and adequacy Value and sustainability of product technology of tech nology


Production techniques, validity of current technology

Teehn leal threats; susta inability of current methods; opportunities for improvement; investment requirements

Intellectual Property Validity, duration and protection of

Rights (I PRs) patents and other I PRs

Expiration; impact and cost

Deeds,land registry records and lease Confirmation of title. Valuation and costs!


potential of property assets


The various national filing requirements Merger control fllinqs and clearance; an


(some of which can be expensive if not complied with); degree of market! information sharing with competitors

assessment of any antitrust risks posed by the target's activities; an assessment of the enforceability of the target's contracts


Present, future and, most importantly, The costs and benefits of retaining risk versus

past exposures of the business. The transferring it

structure and cost of the existing


As mentioned above, often these are combined, so that, for example, Human Resources, IPR and property could be covered by legal due diligence; tax, insurance, IT, operational and pension matters by financial due diligence and management and technical by commercial due diligence. All the above, except property and operational, are covered in later chapters. Property is covered under legal while operational is so highly tailored to the target company

10 Due Diligence

it is difficult to generalize about it much beyond what is said in Table 1.2 and in the appropriate headings in the chapter on financial due diligence.

Different types of due diligence

As well as different due diligence disciplines, there are also different types. Most of this book is concerned with the traditional, buyer-commissioned due diligence prior to the purchase of a private company. There are other forms.


Vendor due diligence (VDD) is the name for any due diligence which is commissioned by the current owners of the business in preparation for its sale. It is a relatively new phenomenon which grew out of the sellers' market of the late 1990s and in particular with the rise of data rooms.

Vendor due diligence is commissioned for a number of reasons most, but not all, designed to control the information flow and so maintain negotiating advantage. As such, vendor due diligence:

• allows the seller to argue that it has provided all the information a buyer could want and therefore no further access to management and customers is necessary;

• gets all the bad news out up front so discovery of problems later is not used as an excuse to chisel the price;

• may be a device for hiding or 'spinning' problems.

And it:

• stops management, advisers, customers and suppliers being deluged by questions;

• is used in some cases by the seller to understand exactly what is being sold.

Buyers should be wary of due diligence reports presented by the seller. The tone of reports, if not the facts, can always be varied according to the brief. Even if the investigations have been conducted by an independent orga nization of the highest reputation, the bu yer wi II not have been privy to the original briefing. lance witnessed a vendor due diligence briefing involving a UK public company which had a potential buyer interested in one of its very weak, and probably unsaleable, businesses, a corporate finance boutique determined to earn its fee and a similarly fee-hungry due diligence consultancy. The 'briefing' consisted of a discussion on what the vendor due diligence should, and should not, say. It amounted to nothing more than a shockingly blatant conspiracy to pull the wool over the eyes of the potential buyer who, sadly, would be blissfully unaware of what had gone on.

The message wi th vendor due diligence, then, is 'watch it'. Vendor due di ligence makes it more difficult for a buyer to form its own opinions, and in some cases it is designed to do exactly that. If given vendor due diligence a buyer should:

1. read it.

2. assess the reputation of the firm which carried out the work - do some due diligence on the due diligence providers.

Introduction 11

3. read between the lines. Note what is not there, but which should be. Sherlock Holmes once solved a mystery because he spotted that a dog did not bark in the night (proof that the crime had been committed by the dog's owner).

4. meet the firm(s) which produced the vendor due diligence (be very suspicious if the seller will not allow this). Ask:

• if the bill was paid in full- if it was not, probe for the reasons. There may have been an

argument about the wording in the final report.

• how many drafts were produced. The more drafts the more the client interference.

• what was re-drafted?

• their overall impressions of the target. (Watch the body language as they answer and listen out for direct questions indirectly answered or not answered at all.)

Given most advisers' paranoia about legal action, these conversations will have to be off the record. Be very sceptical and if the slightest doubt remains, either insist on commissioning further due diligence or pull out. Due diligence which does not rely on the target for information, can, if necessary, be carried out without the seller's knowledge.


Due diligence in public bids can be very different to private or semi-private transactions. With hostile bids, expect, at best, the minimum of cooperation and be prepared to rely on external intelligence gathering and publicly available information about the target company. Commercial due diligence is a good example of intelligence gathering that can be done without the target's cooperation. It is often commissioned prior to an approach that may turn into a hostile bid in order to reassure the buyer that the bid is sensible before it embarks on what is a painful and costly exercise.

If a public bid is friendly, that is recommended by the target's board, some due diligence is possible although given the price sensitivity full unfettered access is going to be a problem until the deal is announced. Even then, due diligence can be a big headache for the seller in public bids in the UK. If a competitive offer comes along, there is a right to information under Rule 20 of the City Code. Rule 20 says that where there are competitive bids the target company has to supply the same information to the new bidder as it did to the originaJ bidder. The slight get-out is that the second bidder cannot just ask for all the information supplied to the first bidder but has to ask specific questions. Nevertheless, this can act as a constraint on due diligence in public bids. It is not unknown for competitors to enter the fray on fishing expeditions rather than as serious bidders. A target company may therefore not want to disclose sensitive information, even to a recommended bidder,just in case a competitor announces a bid and the information has to be handed over.

Warranties and indemnities are unlikely to be given in public bids. Once the deal is done there is usually nobody left willing to give them, aJthough management might give warranties in public to private transactions as a means of helping bankers get comfortable enough to back the deal.

12 Due Diligence


Due diligence for an offering of securities is different from that for an acquisition. The focus is on complete and reliable information on the target company so that underwriters do not misrepresent to potential buyers.


Receivers often allow buyers only a few days to complete a deal. This can severely limit what can be achieved by due diligence. If anything, due diligence is more important with receiverships than with normal acquisitions. If you cannot get proper access for a reasonable time for due diligence you should seriously consider whether or not to go through with the deal, however cheap the target might seem.

For many, the quid pro quo of compressed timescales is that the price is so Iowa few transaction risks are worth taking. However, compared with even distressed prices, risks can be huge and warranty protection will be almost non-existent. In addition, there may be issues around title to stock or the costs of maintaining the goodwill of key suppliers who m igh t have incurred rela tively large bad debts as a result of the receivershi p.

Others will maintain that risk can be reduced by buying the business rather than the company. The issue with picking and choosing which assets and liabilities to take on is that the buyer still needs due diligence information to make a proper, informed judgement.

But the most compelling reason for proper due diligence may be the post-integration issues. The truth is that businesses get into trouble for a reason. Understanding why a company is in receivership could be crucial not only to making an offer but also to turning it round. Turning companies round always takes longer and costs more than was ever envisaged.

Different types of deal

Due Diligence is a term traditionally used for the review process applied to an acquisition. Exactly the same process is, can, and should be applied to a whole range of other transactions, for example:

• the investment by private equity investors to provide development capital to a private company or to finance a management buy-in (MBI) or management buy-out (MBO)

• the provision of bank facilities either prior to lending or when there is concern about an

existing loan

• joint ventures

• strategic alliance

• divestment

• public to private.

Finally, other types of business arrangement might benefit from some, possibly scaled-down, due diligence. For example, a company embarking on a new distribution relationship might wish to make enquiries about the abilities and track record of its new partner.

Introduction 13

Different contexts

The book tends to concentrate on Anglo-Saxon legal practice and on UK law. This is not because European acquisitions are not important, or that it is meant for an Anglo-Saxon audience; quite the opposite. It is simply because:

• The acquisition process, and therefore due diligence, is much more developed in AngloSaxon jurisdictions, so much so that even purely continental European transactions sometimes adopt Anglo-Saxon practices.

• The acquirer should a/ways take local advice in international transactions. This, therefore, is not the place to deal with the differences between law and practice in different jurisdictions. Appropriate advisers will take care of that.

• Despite what many believe, due diligence is not just about the law. The law comes into it in quite a big way but it is not the most important element of the process. It is far more important to grasp the principles of due diligence than to get bogged down in the legal differences between a myriad of different jurisdictions. Again, the important thing as far as the practitioner is concerned is to stay focused on the big picture, using advisers where advice is needed.


Due Diligence is not simply a tool to unearth black holes. Nor is it just to provide ammunition for the negotiations. It does both of these but should also be used as a tool for the longer term.

The academic research in this area shows quite clearly that half of all mergers and acquisitions do not achieve their intended purpose. Other research shows that in the majority of cases this is because the acquisition is not effectively integrated. However good the strategy, however good the choice of target and however good the negotiation of the sale and purchase agreement, poor post-deal integration will seriously increase the probability of a poor deal. Integration must be carried out so that it generates the value the acquisition is expected to bring. It must be conducted quickly, with minimum uncertainty for the acquired workforce and minimum disruption to operations. The key to integration is advance planning. Pre-deal due diligence is the ideal vehicle for the investigative work needed for advance planning. The aim of due diligence should be to give the buyer an assessment of the risks and benefits of the deal both as an aid to negotiation and as an aid to delivering value post-completion.


2 How to structure a due diligence programme

One of the most common mistakes in starting a piece of due diligence is to instruct accountants, lawyers and other experts and let them get on with it. Every deal is different and so, therefore, is every due diligence exercise. Time spent planning and thinking carefully about what is needed will pay enormous dividends when the programme gets going. Time will be short: it always is. Anticipating, and dealing with obstacles is another useful task to make sure is completed very early on. However, even the perfect due diligence exercise will have its shortcomings. This needs to be recognized from the beginning and to be factored into the negotiations.

The preliminaries

The sensible starting point for due diligence is some due diligence on yourself, the buyer, because if you do not know what you want from the exercise you can be pretty sure that no one else will. However stupid that may sound at first, simple answers to many of the acquisition 'process' questions can help prevent wasting a lot of time, money and effort on due diligence and, more important, prevent long-term disappointment with the acquisition in question.

Before diving into due diligence, have the buying team ask itself the following questions:

• What is the business strategy?

• How do acquisitions fit into the business strategy?

• Does the target fit the strategy?

• Have we carried out sufficient pre-acquisition planning? (Buyers can be amazingly

slapdash in this area.)

• Are we sufficiently prepared for the due diligence exercise?

• Which areas are we going to investigate? Why?

• Do we know what we really need to know in each area of investigation?

• Do we have enough time to complete the process? If not, what are we going to do about it?

• Do we know, do we really really know, where the synergies are going to come from? Have we tried to quantify them in detail? What further information is needed?

• Have we set a walk-away price or are we so emotionally involved that we will pay any price?

• Have we worked out an adequate implementation plan?

• Have we explored all the consequences of the deal, for example the effects on current operations, existing personnel, the industry and competitors?

• Have we set materiality limits for the due diligence investigation?

How to structure a DD programme 15

• Have we explained the process to the seller?

• Have we agreed access to people and documents with the seller?

The programme

Doing no due diligence at all is not really a good idea except in the most exceptional circumstances. At the other end of the spectrum, if a buyer carried out every investigation possible to the nth degree, due diligence could end up costing more than the target itself. Structuring a due diligence programme is a balancing act between cost and perceived risk. There are two elements:

• which areas to cover

• how much investigation to do.


Which areas should be covered by due diligence? There are a number of answers to this.

Answer one

The first is that there is no right answer. Due diligence does not have to cover everything and often there will be special areas of concern depending on the deal. Every deal is different and a buyer must decide early on what areas are likely to be the most important. Like very many topics in due diligence, what to cover is a matter of judgement that depends on the business involved. Rather self-evidently, for example,

inquiries regarding the frequency of returned goods are more relevant to a consumer goods retail business than to a management consulting business. Similarly, questions regarding environmental violations are obviously more critical in acquiring a manufacturing operation than in buying a department store chain.'

It is also true that different industries tend to have different risks. In the pharmaceutical industry, for exam pie, the first concern is likely to be intellectual property and the second the state of the distribution. Poor distribution '" poor sales. In the defence industry or in construction, the possibility of corrupt practices will be a concern. In other industries, chemical for example, there will be great sensitivity to environmental risks.

In the end, deciding what to cover in due diligence is a function of how much the buying company thinks it knows about a business and how much risk it attaches to areas where its knowledge is limited. If an acquirer is in the same business and territory as the target company its management will feel more relaxed about the level and scope of due diligence required than, say, when buying a business with a new product or which operates in different geographical markets.

Answer two

The second answer is custom and practice. It would be surprising if a deal were done without some form of legal and financial due diligence. These are the two areas most likely to satisfy the Chairman and the board that the deal is under control. But as pointed out above, 'not

16 Due Diligence

enough planning' and being 'too obsessed with the fmancials to the detriment of other areas' is not necessarily going to result in a successful deal,

Answer three

A third answer, therefore, would look at the integration phase as well as the pre-deal phase. The extent and form of post-deal integration will owe a lot to the reasons for making the acquisition in the first place. Assuming an acquisition is being made for logical, well-thought through, strategic reasons, (possibly an optimistic assumption given the evidencel), as Ioseph L Bowyer points out-, there will be a link between the strategic intent behind a deal and the implications for integration that result. The same link can be made to due diligence. Bowyer lists five good reasons for mergers and acquisitions (!vf&As), each of which, as shown in Table 2. I, is going to mean a differen t due dil igence focus.

Table 2.1 The differen t types of M&A


Strategic objectives

Due diligence focus

The overcapacity M&A

Eliminate overcapacity, gain market share, achieve scale economies

Retaining market share, rationalization costs - especially Hu man Resources and IT

The geographic roll-up M&A

A successful company expands geographically; operating units remain local

Retaining customers; strength of product relative to competition

Product or market extension M&A

Acquisitions to extend a company's product line or its international coverage

Cultural and systems mteqration, strength of product relative to competition

The M&A as research and development (R&D)

Acquisitions used instead of in-house Technical and intellectual due

R&D to build a market position diligence; retention of key people


The industry convergence M&A

A company bets that a new industry is emerging and tries to establish a position by culling resources from existing industries whose boundaries are eroding

Commercial due diligence; technical due diligence; retention of key staff

Following Bowyer's logic, the due diligence process is likely to be most effective if it concentrates on those areas for which the deal is occurring. If market share is the aim then commercial due diligence is called for and it should be structured to give a thorough customer interview programme and a realistic assessment of post-deal competitive position. For example, despite a host of acquisitions, American companies have failed to capture as large a share of the UK greetings card market as perhaps they should. The reason for this is that apparently retailers prefer to multiple source their greetings cards so as one company is swallowed up by another, customers simply take their business elsewhere. Buying for market share just does not work.

How to structure a DO programme 17

Answer four

A fourth answer is to do with the likely degree of integration and the speed of its planned implementation. The faster a buyer wants to do things, the more it is going to want to know about the target up front.

Answer five

A fifth answer is to investigate at least those areas where key exposures are likely to lie. To an extent these will be deal specific and they are often in non-financial areas:

• IT systems - non-compatibility with existing systems

• Contract commitments

• Employment terms

• Financial instruments and hedging activities

• Environmental matters

• Compliance with existing laws

• Outstanding litigation.

Answer six

A sixth and final answer is to cover those areas which pose the greatest risk in transactions, unless the buyer's existing knowledge is good enough for it not to have to bother with some of them. Surveys based on acquirers' past experience show these to be (in order of importance):

• Market/Customers

• Management

• Financial records and projections

• Competition

• Product/technology

• Legal issues

• Environmental investigations.


There is absolutely no right answer to the question, 'how do you know when you have done enough due diligence?' There is a theory that the more extensive the contractual protection, the less the need for due diligence. This is dealt with later, but is only partially true. In the end it comes down to comfort. When you feel comfortable making a firm recommendation which, if it is for the deal to go ahead, is supported by synergy papers and a fully costed list of post-acquisition actions, you can stand down the due diligence team.

In structuring a programme buyers should always remember that due diligence is not about ticking boxes on a checklist. It is not just about collecting lots of information. It is undertaken so that the correct decisions can be made. These could be:

• Buy/Don't buy

• Negotiate a [ower price

• Prioritize warranties and indemnities

• Draw up a proper post acquisition implementation plan

And so on.

18 Due Diligence

Instead of ticking issues off a list, focus on issues as they arise. 'View the effort as a series of independent mini-investigations with respect to key issues'A

An acquirer cannot discover every possible risk, The effort required would mean running out of time, resources and testing the patience of the seller to the limit, not to mention cost. Regardless of what would be ideal, in practice time, money and the seller are going to dictate how much investigation a buyer can do. The key is to be thorough but reasonable.

Doing too much could, in fact, be counter-productive. The reason for this can lie in the terms of the acquisition agreement. With the normal purchaser-drafted acquisition agreements, what due diligence has found is not really an issue. These usually say exactly that by including a clause to the effect that the purchaser's prior knowledge of a particular matter is no defence by the seller to warranty claims unless the matter is actually disclosed in the disclosure letter (warranties and disclosures against them ate covered on page 27 below). This is a common approach and means that only matters disclosed in the formal disclosure letter are treated as qualifying the warranties. The commercial objective is obvious: the parties are clear as to the warranties given in the sale agreement, and to the disclosures which qualify them. However, the courts have not always been entirely comfortable with this approach, as in the case of Eurocopy PLC v Teesdale.

In Eurocopy PLC v Teesdale the court held that the purchaser's knowledge outside the matters disclosed in the disclosure letter might be pertinent in assessing (that is, reducing) the purchaser's claim for breach of warranty. In this case, the vendors had warranted that all material facts had been disclosed. The acquisition agreement also contained the standard clause mentioned above that, apart from information set out in the disclosure letter, the purchaser's knowledge of the target was irrelevant. The Court of Appeal's logic was, among other things, that when the purchaser decided to pay over the odds for the shares it must have taken into account the matters that it was now complaining about so it was no good coming along and claiming a loss now.

There are aJJ sorts of problems with this judgement but it will be a long time before it is tested again. In the meantime, purchasers should be wary of making warranty claims for matters on which there is evidence that they had knowledge. This could mean limiting due dillgence and it certainly means not disclosing due diligence findings to sellers even if they request them in the nicest possible way. Their request could just be a ruse to limit liability under warranties based on the precedent set up in Eurocopy v Teesdale.

Getting the information

The specific sources of information for each of the specialist due diligence areas are covered under the relevant chapter headings, but there are a number of general points to be made.

It almost goes without saying that throughout the process, the buyer should be sensitive to the stress on its own personnel and on its relationship with the seller:

• Due diligence is a major disruption.

• In non-Anglo-Saxon countries, it is often seen as a sign of mistrust by the seller.

• Sellers will always be afraid of the consequences for the future of the business and lor its sale to someone else if the deal does not go ahead.

Even with a perfect relationship between buyer and seller there are a number of obstacles to contend with.

How to structure a DD programme 19

Dealing with obstacles

It would be nice if buyer and seller could draft Heads of Terms, shake hands and then spend a couple of months helping the buyer's advisers find, comb through and make sense of the mass of inform arion they wi I I inevi ta bly wa nt. It never quite works like that. For a number of reasons, buyers must overcome a number of obstacles which may be placed in their way.


Due diligence relies heavily on information from the seller and on access to the target's management, facilities and advisers. Nothing very much is likely to happen until prospective buyer and seller have agreed on confidentiality undertakings.

The fact that negotiations are taking place probably gives rise to an implied obligation on the part of the buyer to keep everything confidential which the seller and its advisers disclose. Nevertheless, sellers usually require the comfort of a signed confidentiality agreement before they release any information.

As a minimum, the seller wiIl want such an agreement to require the purchaser and its advisers to:

• keep all disclosed information confidential

• take all reasonable steps to keep it safe and secure

• disclose the information only to those employees and advisers who need it for the transaction

• use the information only for assessing the prospective transaction

• return all documents (including copies) at the seller's request or at the conclusion or termination of negotiations.

Where buyer and seller are direct competitors there may be further clauses through which the buyer promises not to solicit any of the targets customers or employees during negotia nons and for some time after if the deal does not com plete,

Although notoriously difficult to enforce, sellers, or more likely their legal advisers, take confidentiality agreements extremely seriously. As a result they are tend.ing to become excessive in their demands. This means that these agreements have to be negotiated which in turn adds delay to what is usually already a fairly tight timetable. The thing to remember is that rarely do parties go to law over breaches of confidentiality agreements so it is better to sign them and get on with the due diligence than waste a disproportionate time quibbling. Restricting the due diligence programme is definitely something which is in the seller's interest and a protracted fight over the terms of the confidentiality agreement could be exactly what the seller had in mind.

On the subject of confidentiality, it is worth asking the target before due diligence gets underway whether it itself is bound by any confidentiality obligations. For example, joint venture agreements may prevent the target disclosing certain information to a purchaser without the partner's consent.


Many of the obstacles listed below, and throughout the rest of the book, arise because of an

20 Due D iii 9 e n c e

inherent conflict between buyer and seller. The buyer wants to see and understand everything before being bound to a deal. The seller wants to give nothing away until the buyer is bound. These natural differences are often exaggerated in cross-border deals:

• for cultural reasons

• to gain a tactical advantage.

The technical issues in cross-border deals are usually quite straightforward, especially with good local advice. For example, even where civil codes, in theory at least, mean there is no need for warranties, warranties are usually acceptable because there is an acceptance that where a deal is being done with an Anglo-Saxon, an Anglo-Saxon format can be used. Crossborder deals do require more management, and language can be a problem, but what is really difficult are the cultural issues. Very often these cultural difficulties can be avoided by simply trying to understand where the other party is coming from. Differences brought about by different legal philosophies are a good example of how simple ignorance can lead to major difficulties.

For example, the French civil law system is radically different to the English common law system. An important difference as far as the law of contract is concerned is that whereas English company law favours complete freedom in contract negotiations, French law seeks to protect the weakest party to the transaction, the buyer. As a result, French law imposes a duty of good faith on the seller. This is the complete opposite to the English doctrine of caveat emptor. In France, the seller owes a duty to the buyer to disclose any fact which might have a bearing on the value of the target. As a result, there is no need for most forms of due diligence, at least not to find deal breakers or negotiating issues, and much less emphasis on contractual protection.

Hardly surprisingly, therefore, the comprehensive Anglo-Saxon approach to due diligence, followed by an exhaustive set of warranties and indemnities, is sometimes viewed by French vendors as over the top. On the other side, failure by the French vendor to discuss such issues seriously is often viewed by a potential UK acquirer as an indication that the French vendor has something to hide. Knowledge of, and sensitivity towards, such differences will go a long way towards diffusing them as obstacles. Flexibility, patience, persistence and the use of local specialists all help too. An aggressive approach normally succeeds only in exacerbating cultural obstacles.

In short, standard approaches will not work with cross-border transactions.


The whole point of due diligence, as far as the buyer is concerned, is to find out more about the target company. Not surprisingly, therefore, the buyer will want to retain its freedom to re-negotiate some of the fundamental issues that might have been included in the Heads, such as the price. Also, a buyer will not want to be fully committed until the investigation has been completed and there is adequate contractual protection in place against pre-sale liabilities through clauses in the main agreement.

Unfortunately, the legal consequences of 'Heads' differs markedly by country. In civil law jurisdictions, Heads of Agreement can virtually commit the acqutrer to doing the deal on the terms specified, unless they are carefully worded. In general, courts examine the intent of the parties and the completeness of the agreement to determine its enforceability. In common

How to structure a DD programme 21

law countries, such as England, the document is little more than a non-binding agreement to negotiate.

At this paint a sensible purchaser will also insist on a period of exclusivity. Exclusivity is a period during which the seller agrees not to discuss the sale with other interested parties or encourage such interest. Due diligence is expensive and time consuming and a would-be purchaser does not want to go to the trouble and expense if there is a risk of another bidder walking away with the target before it has had a fair chance to bid. The sanction for breaking the undertaking is often that the seller will pay the potential purchaser's due diligence costs.

Therefore, if there are Heads of Agreement, before starting due diligence it is vital for the buyer to make sure that the document:

• is legally non-binding on the buyer

• contains 'lock out' or 'standstill' clauses giving the buyer exclusivity (although in many countries the existence of Heads of Agreement - or even negotiations - creates obligations to negotiate in good faith).

The seller will probably also want to see confidentiality provisions and both may want clauses which deal with liability for costs in the event of an abortive transaction.

Al! the above, especially in civil law jurisdictions where the risk of inadvertently creating a binding agreement is greatest, means a short document which:

1. has an introductory paragraph clearly stating that the purpose of the letter is to create either wholly non-binding, or a combination of binding and non-binding, obligations on the parties

2. refers throughout to 'prospective buyer' and 'prospective seller'

3. uses the conditional, words like 'would' and 'might', in non-binding clauses

4. includes a list of all conditions that must be satisfied before the agreement is binding

5. has a summary at the end which:

• says the agreement is generally non-binding

• lists the paragraphs that are binding

• states that the existence of the document is not proof of intent on the part of either party

6. is possibly left unsigned.

It is perfectly possible to start due diligence without Heads of Agreement. Heads of Terms are by no means universally employed and in many transactions are actually quite difficult to draft in any detail prior to due diligence, which rather defeats the object.


For understandable reasons, the seller will often not reveal sensitive commercial information until the last possible minute. Sellers do not want to hand potential (or in many deals, existing) competitors information which could damage the business if the deal does not go ahead. The profit made on each product and from each customer, gross margin by product by

22 Due D iii 9 e n c e

customer, is not something a seller wants outsiders to know. Unfortunately late disclosure may lead to last-minute negotiations, especially if the information turns out to be different from what the buyer had expected.

In other types of deal, such as public bids, the limits on the amount of information available to the acquirer are often severe, forcing the acquirer to rely more on alternative sources of information than those provided by the target.


Site visits are important means of collecting due diligence information. From the seller's perspective it is natural to want to keep the proposed sale from employees. However, a seller should provide reasonable access to key personnel, and it is worth pushing very hard for proper access for the following reasons:

1. If the seller is intending to preven t top managemen t from responding to the due diligence request, any meaningful due diligence investigation will be virtually impossible.

2. Top management often proves more willing than the seller to disclose matters that the purchaser should know, such as:

• who else is bidding

• what sort of prices have been offered

• where the real problems are and which of the 'problems' are not problems.

Target management will often have been Incentivrzed to get the deal done but, unless the deal is known for certain to involve their wholesale removal, they know which side their bread is buttered - which is why smart sellers will try to deny access to management in the first place. If access is given, make sure you and your team treat management with respect. Do not let your advisers mess them about or make life difficult for them, do not let them make unreasonable or silly requests and remember they also have a business to run. Make sure their life is as pleasant as possible and you will get a lot more out of them.

If the buyer is denied proper access but still wants to go ahead with the deal, it is a question of using whatever mechanism possible to gather information. In one transaction the selling company insisted that its (female) group financial controller sat in on all discussions between the financial staff of the target and the buyer's financial due diligence investigators. Needless to say the most controversial topics were covered in discussions in the gents'toilet.

Of course in trying to restrict information, access or time, a seller may be playing to one of the few negotiating strengths it has. As a buyer, it is a good idea to test this early on by making it dear that you want to do due diligence before buying the business, that you are going to do it right, and on your terms, and if this cannot be agreed then you will abandon the purchase.


It is absolutely reasonable for a vendor to wish to protect the confidentiality of the discussions; indeed it is in the acquirer's own interest to avoid any rumours in the market which may harm the target's relationships with its customers. Nor does a seller want

How to structure a DD programme 23

customers' suspicions aroused by a sudden volley of phone calls from consultants purporting to be studying the market or carrying out a customer care programme on behalf of the target. The seller will have to live with these customers afterwards if the deal does not complete.

What is not reasonable is for the vendor to seek to prevent a would-be acquirer in exclusive negotiations from talking on a confidential or undisclosed basis (more about this later) to the people who know the real strengths and weaknesses of the company and/or the company's technology or products. Again the seller may only be playing a negotiating game. Test this. If you still get no joy, remember that not even the most bloody-minded of sellers can prevent consultants finding and talking to customers on an undisclosed basis. Just allow extra time.


Every seller will do everything possible to convince a would-be buyer to accept the shortest possible due diligence period. Corporate finance firms in particular are very good at creating time pressure. It is in both their interests to do so. The more time a buyer has, the greater the chance of it finding something it does not like. If the timetable imposed on a buyer is unfeasibly tight, alarm bells should ring. Most timetable issues are moveable and indeed by the time discussions get round to due diligence timetables, the seller is so close to a deal it would be foolish to alienate a prospective purchaser for the sake of a couple of weeks' extra investigation - especially if the business is as good as it appears to be from the seller's sales pitch.

Most advisers will need three weeks to carry out their work and more if they come across unexpected issues or problems which need further investigation. Add to this, time to digest their findings and you can see that due diligence needs a month at the absolute minimum. If the seller or the seller's advisers will not budge, you should seriously consider walking away. If not, try to negotiate a break fee, at least then due diligence costs will not be wasted if the work is not completed in time.

It is not always the seller's fault that the timetable is too tight. Often the buyer is to blame. Many buyers hold off from briefing advisers until the very last minute, just in case the deal does not happen, only to find that they have ended up not leaving anywhere near enough time for proper investigations.

If the timetable is genuinely not moveable, and only a limited due diligence exercise is possible, the purchaser should at least seek to investigate key issues and take other precautionary steps, for example, ensuring that the warranties and indemnities are appropriately wide or by negotiating a retention of the purchase price to cover potential warranty claims. A selling company which has restricted the would-be acquirer's due diligence programme will be in a weak negotiating position if it then tries to restrict warranties and indemnities as well.


A common due diligence problem is the sheer volume of material available during the process, leading to useful information becoming concealed in irrelevant or unfocused data. As mentioned above and in the next chapter, focus is paramount.

24 Due D iii 9 e nee


There is an art to dealing with the straightjacket that data rooms attempt to impose but this is probably beyond the scope of this book. The objective of a data room is to give potential purchasers enough information for them to submit indicative bids. It is in the seller's interests to put in as much non-sensitive information as possible, and especially all the problems. If a seller gets all the problems out at the beginning of the sale process while there are a number of interested parties, it leaves itself much less vulnerable to purchasers chipping away at the price. If there is only one bidder left, the seller is much more vulnerable to a 'take it or leave it' type of negotiating stance if the buyer comes across unexpected problems.

Following indicative bids, a shortlist of bidders will be drawn up. These will usually have access to the more confidential or sensitive information and be allowed to conduct normal due diligence.


Not all sellers, or their advisers, tell the whole truth all of the time. In certain cases in the UK this is a criminal offence.

According to The Financial Services and Markets Act 2000, Section 397,

(1) This subsection applies to a person who ~

a) makes a statement, promise or forecast which he knows to be misleading, false or deceptive in a material particular;

b) dishonestly conceals any material facts whether in connection with a statement, promise or forecast made by him or otherwise; or

c) recklessly makes (dishonestly or otherwise) a statement, promise or forecast which is misleading, false or deceptive in a material particular.

(2) A person to whom subsection (1) applies is guilty of an offence if he makes the statement, promise or forecast or conceals the facts for the purpose of inducing, or is reckless as to whether it may induce, another person (whether or not the person to whom the statement, promise or forecast is made)-

a) to enter or offer to enter into, or to refrain from entering or offering to enter into, a relevant agreement; or

b) to exercise, or refrain from exercising, any rights conferred by a relevant investment.

(3) Any person who does any act or engages in any course of conduct which creates a false or misleading impression as to the market in or the price or value of any relevant investments is guilty of an offence if he does $0 for the purpose of creating that impression and of thereby inducing another person to acquire, dispose of, subscribe for or underwrite those investments or to refrain from doing so or to exercise, or refrain from exercising, any rights conferred by those investments.

The wording is very wide. As already mentioned, the offence is criminal. Sellers, and their advisers, involved in UK transactions should therefore think very carefully before they say or

How to structure a DD programme 25

conceal anything they think might be material to a buyer trying to decide about a transaction. The provision would apply even to the old estate agent's negotiating trick of telling a potential purchaser that there is another buyer who has offered to pay more.

Another side of Section 397 is that vendors will be particularly concerned to avoid liability for statements made by employees during due diligence that are negligent or innocently made but just plain wrong. They will seek to do this with a clause which says something along the lines of,

The purchaser has not relied on any representation or undertaking whether oral or in writing save as expressly incorporated in the agreement.

Note, however, that where fraudulent misrepresentations can be proved, this clause in an agreemen t is not sufficient to exclude liability under the Misrepresen ta tion Act 1967.


As is discussed later under commercial due diligence, respondents can be misleading without deliberately lying. This can happen for perfectly innocent reasons: for example they can get facts confused or try to hide the fact that they are not as knowledgeable as they should be. The due diligence practitioner, whatever the discipline, should always:

1. bear in mind that the nature of information im pacts on its reliability:

• Internal information is usually more reliable than external.

• How and from whom it is obtained can be important.

• More reliance can be placed on information that is independently verifiable.

2. Be on the lookout for inconsistencies that are material.

3. Ask open-ended questions in interviews.

4. Remember that past behaviour can be a good predictor of future behaviour.

Much of the really useful information will come from interviews. Where these are face-toface, say with target management, it is always useful to have two interviewers. One is there to listen to the answers, the other is there to watch the answers. It is amazing how much body language can tell you.

There is no substitute for walking around. Even the relatively inexperienced eye can spot a poorly run factory so imagine what the experienced eye can see. The world of due diligence is full of stories of what has been unearthed simply by going to look. 'If the new automated welding system really is bedded in and working, why is there a crew of welders at the end of the line? Are they there, by any chance, to correct errors?' 'If the new computer system has truly created the paperless office, the workforce have not been told because there are piles of paper everywhere.'

How much information is verified is going to be largely based on the buyer's or due diligence investigator's opinion of the source of the information. As a rough guide, the following will always require verification:

• Information that is not publicly available

26 Due D iii 9 e n c e

• Any details of future contracted business

• The existence of physical assets

• Product warranties

• Anything which does not seem believable

• The background of directors and senior staff

Dealing with the shortcomings of due diligence

The fairest and probably most sensible way of apportioning liabilities is to make the seller liable for everything pre-completion and the buyer for everything post-completion. Trying to achieve this happy balance cannot be achieved through due diligence alone. However thorough the due diligence, it is not a substitute for legal protection in the contract. Due diligence and warranties and indemnities should be seen as separate weapons:

• Due diligence cannot uncover or quantify the size and likelihood of every acquisition risk.

Legal protection therefore serves as a second line of defence.

• If the seller does not tell the purchaser the truth or does not tell the purchaser the whole story in response to questions, the buyer might find that there are very few remedies. The Financial Services and Markets Act 2000 mentioned above does not provide a civil remedy and so does not give the purchaser the right to seek monetary compensation. Although a purchaser induced to enter into the sale agreement by misrepresentation may be able to rescind the sale and/or claim damages, oral misrepresentations are notoriously difficult to prove and so purchasers usually seek express representations.

The case for express written representations (or warranties) in the sale agreement is further reinforced, at least in Anglo-Saxon jurisdictions, for the following reasons:

• Under English law, the principle of caveat emptor or 'buyer beware' means that virtually no terms are implied in favour of a purchaser of shares in a target company. Consequently, protection must be dealt with by express contractual provision.

• Purchasers cannot even rely on audited accounts (see Chapter 4, Financial Due Diligence, for more details).

The theory that the more extensive the contractual protection, the less the need for due diligence is only true to a certain extent. The normal form of contractual protection, warranties and indemnities, is only as good as the covenant of the giver. If, for example, the giver does not have the financial wherewithal to meet warranty claims, or simply disappears, the purchaser will be left out of pocket. A purchaser must, therefore, use all the means of protection available: due diligence, warranties, indemnities, reductions in the purchase price, retentions from the purchase price, earn outs, guarantees, insurance, the exclusion of certain assets and remedial work at the seller's cost.

Furthermore, there is no substitute for knowledge of the target and its affairs in trying to negotiate comprehensive warranties and indemnities, and no better means of getting it than through due diligence. The better the due diligence, the more specific the 'express contractual provision' can be.

How to structure a DD programme 27

Legal protection is therefore used alongside due diligence and usually takes the form of warranties and indemnities. It is the function of both to limit the workings of caveat emptor. They do this in different ways.


A warranty is in effect a 'guarantee' by the seller that a certain state of affairs exists. Warranties are statements of fact which the seller confirms to the purchaser as being true. An example might be that the target company is not involved in any litigation. If the seller knows that this is not actually true, the seller discloses the real facts (for example, the details of the actual litigation) in a separate letter. With a touch of creativity rare in the legal profession, this is called the disclosure letter. If the seller disclosures exceptions to the warranties, it will not incur any liability under the warranties for the matters disclosed. If the buyer tries to claim for one of these items, the seller can say, 'but I told you about that, you went into this with your eyes open, it is no good trying to claim now.'

As the purchaser is to a large extent relying on what the seller has disclosed, it would be wise to seek extra protection in the form of warranties guaranteeing the accuracy of information. If the information then proves to have been wrong, the purchaser can claim damages.

As no warranties will be given for items disclosed, buyers must be careful of incomplete disclosures. Partial disclosure can make the contractual protection of any associated warranty ineffective.

Warranties have two functions as far as a purchaser is concerned. The first is that the disclosure letter usually contains a lot of useful information about the target company. Clearly if it flags up liabilities which were previously unknown, the purchaser may try to negotiate a price adjustment before the deal is done. The second is contractual. Any breach of the guarantee given by the warranties which has a bearing on the value of the target entities the purchaser to a retrospective price adjustment. That is to say, where there is a breach of warranty, a seller company who can prove loss is entitled to damages to put itself back in the position it would have been had the warran ty been true.

The problem with warranties is that there may be difficulties in relying on them in the event of a breach. These are normally one of two types:

• Difficulties of proof - either that there has been a breach or that there has been a loss resulting from it.

• Disclosures - the warran ty will not normally apply if breaches of the topic in question have been disclosed.


An indemnity is a guaranteed remedy against a specific liability. The buyer is entitled to it regardless of whether:

• or not the val ue of the target is affected

• the liability in question is disclosed to the purchaser in the disclosure letter.

Indemnities enable the purchaser to adopt a 'wait and see' policy, especially where the liability in question is contingent and it is uncertain to what extent, if at all, it will crystallize.

28 Due D iii 9 e nee

The sale and purchase agreement can identify the particular problem and provide that if that liability crystallizes the purchaser will be compensated for the loss suffered. One of the most common indemnities is an indemnity against tax liabilities. Here the vendor promises to meet a liability should it arise.

Whether or not a warranty or indemnity is adequate depends on the financial worth of the seller. If the sellers are not particularly creditworthy or, for example, have moved their assets to an offshore jurisdiction, some security may be called for. This could take the form of a deposit of funds in an escrow account, a third party guarantee or even retention from the purchase price for a stipulated period after completion.

The width of an indemnity wiIJ depend upon its wording and it should not necessarily be assumed that all losses win be recoverable. Indemnities have the following limitations:

• They will not cover wilful and culpable acts.

• Difficulties of proof may make indemnities difficult to rely on, as can difficulties in establishing quantum.

• Indemnities may not always cover economic loss.

• Indemnities may be limited in time and be financially capped.

There are all sorts of twists and turns on these basic themes which get the lawyers terribly excited but these are beyond the scope of a book on due diligence. For example it is possible for a tax liability to give rise to both a breach of warranty and an indemnity claim. The most important issues as far as due diligence is concerned are:

• First, as mentioned above, to what extent will what you have found out in due diligence be treated as actual knowledge as if it had been in the disclosure letter?

• Second, and related to the first point, should a buyer reveal its due diligence findings to the seller?

• Third, what are the issues to be taken into account in establishing a loss or a breach of warranty (because this might have a bearing on how much due diligence to do and how to make sure claims are properly made once the deal is done)?

It is usual for the buyer's solicitor to produce a standard set of warranties and indemnities. These should be tailored to meet the buyer's specific concerns before being sent to the seller. In cross-border transactions the flow of information may not be quick enough to allow this so warranties may need to be revised later once the information does come in.


As warranties tend to be the bigger issue here, the comments which follow are addressed specifically to warranties although many of the principles also apply to indemnities.

As already mentioned, for warranty claims there has to be breach of a specific warranty and there must be loss. The issues around claiming include:

• Time limits: the seller will usually try to restrict the time in which a claim can be made.

• Procedure: the agreement will set out formal requirements for making a claim.

• Loss: the general principle is that the purchaser is entitled to the difference between the value of the company as warranted and its actual market value. It goes without saying that

How to structure a DD programme 29

in assessing market value each party will argue for a valuation method that produces the most favourable valuation for them.

• Amount: the seller will normally seek to impose both a minimum and a maximum level of claim with the ceiling often fixed at the consideration paid.

Because of the difficulties with warranty claims it may be better in some circumstances for the purchaser to pursue a claim for damages instead.

There is one final and very important point under this heading. Whoever is responsible for integrating and/or running the target business once the deal is done must be made fully aware of what warranties and indemnities have been agreed and what the procedures are for claiming under them. When a deal is done, the acquisition team tends to move on and hand over to line managers. Line managers do not have a natural inclination to go to law when a problem appears and unless the notion that there is contractual protection is thoroughly ingrained there is a strong chance that they will not make use of it.

Other forms of protection

As mentioned above, apart from legal protection in the form of warranties and indemnities, other forms of protection can always be negotiated following adverse due diligence findings. These include:

• Price adjustment

• Retention from the purchase price

• Earn outs

• Third-party guarantees

• Insurance

• Asset sale rather than a share sale

• Exclusion of certain assets and liabilities from the acquisition

• Rectification of any problems at the seller's cost.


One of the secrets of due diligence is knowing what is required, from whom, and when - in other words, project management, pure and simple. Good planning and active management are paramount. Start right at the very beginning. Why you are doing the deal and what you hope it will achieve will be vital pointers as to what due diligence needs to achieve and therefore which areas need to be covered to what degree. However, there is no escaping the fact that in due diligence judgement plays a big part. There are few right answers. What and how much to cover in any deal is a matter of judgement.

Managing the project means managing not just advisers (the subject of the next chapter) but managing the seller and its advisers also. Obstacles to honest investigation cannot be helped, but they can be managed.

One of the great benefits of a properly executed due diligence programme is that it highlights areas of uncertainty which can be ring-fenced by warranties, indemnities or other forms of protection. The buyer should not regard either due diligence or legal protection as substitutes for each other. They are separate, complementary weapons to be used in tandem.

CHAPTER 3 Working with advisers

The one thing all principals need to remember about due diligence is that to get the best out of it, it has to be managed. The pace of the deal and the diverse range of expertise which must be deployed means that advisers are usually a feature. It is very important to select the right ones and as they are expensive, getting the best out of them is as much of an issue as anything else in due diligence. Like all project management, the keys are to plan what needs to be done by when and by whom, coordinate the efforts of all involved and communicate, communicate, communicate.

Why bother with advisers?

Whatever they tell you, and whatever some of them may actually believe, there is no particular magic to what due diligence advisers do. There is also no rule which says a buyer cannot do due diligence with its own internal resources. In fact every buyer usually does take an active part in some part of the due diligence process. Doing it yourself has the advantage of saving money and it also develops an in-house acquisition expertise. Some even claim that using in-house due diligence teams improves confidentiality. The fact is, though, that most due diligence exercises use outside professionals to a greater or lesser extent. The question, then, is why? Why do buyers usually instruct professionals to carry out the investigations?

The reason is that they can bring a lot to the event:

• Experience. Advisers have done it all before. Advisers should, therefore, be pretty efftcient at getting through the task in the ridiculously short time available.

• Expertise. Advisers will be experts in their own specialist field. As such they will not only be good at spotting problems, they are usually pretty good at solving them too .

• Judgement. Due diligence often calls for judgement. Good judgement is helped greatly by experience and expertise. Not just anyone can provide reliable judgements, for example legal due diligence findings will need legal judgement.

• Resources. An acquisition is a time-consuming exercise. A buyer simply may not have the manpower to conduct due diligence. Using outside professionals will leave the buyer to concentrate on the bigger commercial picture.

• Access. Accounting firms are normally given access to the target's auditors' working papers and tax files. This would usually be denied to others. Often sellers will tell third parties a lot more than buyers who are often also competitors.

• Speed. More often than not the possibility of buying a business presents itself as a fleeting opportunity. Deadlines are always tight. It is very difficult to ensure that adequate due diligence and planning have taken place without bringing in external resources to aid in the process.

Working with advisers 31

• Comfort. Knowing that a professional has investigated the target company is much more comforting than doing it all yourself and wondering what you might ha ve missed. J t is also a lot more comforting to third parties in a transaction such as banks, stockbrokers and merchant banks.

• Internal politics. Acquisitions can very often mean empire building. Advisers are usually not part of the politics. Not only can they just get on with the job but they can also deliver any bad news much more easily than an employee whose first thought might be the career-limiting implications of delivering the 'wrong' message.

• Objectivity. As an acquisition proposal is tabled, discussed and analysed within the acquiring company, it builds up a momentum all of its own, Once the proposal has been put to the target company, agreed in principle, and all the negotiating and investigating machinery has swung into action, that momentum becomes a powerful force. By this time a number of people within the acquiring company - some of them quite senior - have invested significant amounts of time, energy and credibility. Other things being equal (which often they are not) it is much easier for someone who is not from the acquiring company to bring an objective viewpoint.

• Corporate Governance. As mentioned in Chapter 1, The Cadbury Report recommended that Significant acquisitions should be considered by the full board of directors of the purchasing company. Cadbury recommended that non-executive directors should playa 'devil's advocate' role. This role is virtually impossible without independent reports from professional advisers. Without them the non-executives could only rely on the executive management.

• Anonymity. Unless an in-house team goes to some length to disguise its identity, it will be unable to use certain sources of information (for example, competitors). Its activities may well also advertise what is going on and spark interest from other parties.

• Confidentiality. Confidentiality is probably easier to maintain in firms of professional advisers.

Taking control

Managing advisers means controlling the process right from the start. Sadly for most buyers, this means spending time planning the due diligence campaign. Time is always constrained, so to make the most of it, prepare properly. The rules of control are:

• First, the buyer controls the process, not the advisers.

• Second, advisers are there to give advice and not to make decisions. It is for the principals to make decisions.

• Third, do not be unrealistic about your demands.

• Fourth, advisers must be properly briefed. However much they are under your control, advisers will not do what is expected of them if they are not properly briefed.


Advisers cannot be expected to turn in a half-decent job unless they know what is going on. Before they start they need to know:

32 Due D iii 9 e n c e

• Which other professionals will be working on the deal, what they are doing and where the focus of their investigations will be. Naturally this should include a briefing on any due diligence which the purchaser will be undertaking himself.

• The reasons for doing the deal and the areas of greatest worry .

• Acceptable risks/materiality limits. The last thing you want is a report that covers every little detail. Setting materiality levels helps avoid this by specifying acceptable risk thresholds. If only risks above £100000 are a worry, say so then the adviser does not have to report on anything beneath the threshold, unless there is a chance of it turning into something much bigger.

• The specific industry risks. For example the risks in the food industry are quite different to those in the pharmaceutical industry .

• The structure of the deal. A share purchase has very different implications to an asset purchase.

• What the key issues are and what is irrelevant. A colleague, for example, tells a story of due diligence which identified a downward sales trend in one product line. Before setting off to investigate why, he thought what had been found out should be mentioned to the client. The client in fact already knew and was not in the least concerned as it was the client's own product range which was picking up the lost share.

• Precisely what is wanted from the exercise. One of the reasons why due diligence reports run to several hundred pages of often unrelated, but very detailed, facts is that the client has not specified (or not got across) what is wanted both in terms of the information needed and how it should be presented. Raw data is no good; it needs to be evaluated by seasoned professionals. Say so. In the absence of a proper briefing, advisers will go out and collect everything.

• The deal timetable.

At the end of the briefing it is a good idea to test advisers to make sure they know what they think they are looking for and that they definitely know what the buyer wants them to look for. Professional advisers are very good at pretending that they know everything about everything. It pays to disabuse them of this nonsense. Encourage them to si t with you, probe, ask questions and listen to the answers. Review their information request or question set before they send it to the target. Above all, do not let them set off to solve a problem before it has been properly explained to them. Many do.

Al! of the above just serves to reinforce the second last of the above bullet points. Before you commission due diligence, you must think pretty carefully about what information and analysis is needed. This will not only keep the due diligence team focused, but will also keep costs down. Saying to advisers, 'tell me everything you can possibly find out' is a little like writing an open cheque. If the potential acquisition has been properly researched and the rationale for its purchase evaluated, a fairly logical set of due diligence issues should fall into place.

Beware: left to their own devices advisers will work quite independently of each other.

This you do not want. Encourage them to work together. For example, accountancy firms are notoriously reluctant to put their names to a forecast. A commercial due diligence provider will gladly come up with forecasts, but will usually not provide numbers. Getting the two to work together has got to make sense. Similarly, lawyers will examine legal structure and may find that liabilities will be triggered if the target leaves its present group. These could, for example, be capital gains tax liabilities because of inter-group transfers of assets or additional

Working with advisers 33

costs because the target company can no longer benefit from group discounts. The accountants need to build these into their model,

Selecting advisers

There are two aspects to selecting advisers

• Which services do you want?

• Who do you choose to provide them?

The answer to the 'which services' question is going to be different for every deal. The question was covered under 'The programme' in the previous chapter. It will be a function of deal size, knowledge, and perceived risk.

The most reliable way to select the right advisers is to find key advisers and, over time, build personal relationships with them. You are not going to be able to build working relationships while under the stress of a deal so take the time and trouble to do that before you get stuck into a transaction. To find individual advisers who have expertise and integrity, ask people's opinions. Take time to meet advisers and get references from previous clients to understand exactly what their role was and how they performed. By taking time to build working relationships, advisers will get to understand your business and your long-term strategy; for your part, you will feel comfortable with the prospect of working with them. The people element is at least as important as the technical element. Appendix Al gives a checklist for selecting (and working with) advisers.


Technical ability and experience are important in choosing which advisers should carry out what work, but so are personal chemistry and seeing what lies behind the typical adviser's sales veneer. The following is an extract from a letter to the Financial Times describing Enron, but the sentiments could easily be applied to a great many due diligence advisers.

It promoted itself beyond the limits of truth; it offered for sale things it had not quite finished buying; it spoke of funds it had almost, but not quite, garnered.'

Honesty and integrity should be important selection criteria. What every acquirer wants is an adviser who is looking out for the acquirer's best interests and who is not just interested in getting a deal done in order to earn a fee. The DTI report into Robert Maxwell's business affairs2 recognized advisers' pursuit of the fee as one of the problems which allowed Maxwell to carry on as he did, 'Maxwell was an attractive client, He was a prolific deal doer. , , and he paid well. '3 A 3i executive sums up the problem as follows,

I am fed up of reading due diligence reports which conclude, 'from our initial inquiries we conclude that this would not be an attractive MBO candidate' and then go on to say, 'we look forward to continuing with the investigation.' Who do they think they are kidding?

Besides the obvious questions like 'Can they get the job done?' and 'Are their fees

34 Due D iii 9 e n c e

reasonable?' the buyer should also be asking 'Can I really trust these people', 'Can I work with these people?', 'Me they really as good/as experienced as they claim?' and' Will they give me strong opinions based on their experience or are they only interested in covering their back?'


After interpersonal factors comes the right mix of experience and skills. Experience required in order of importance is as follows:

1. Experience of carrying out due diligence

2. Experience of the purchaser

3. Experience of the target company's sector.

In other words, the most important skill is preparing due diligence reports for different companies; knowing the purchaser and the sector are additional benefits.

Sector knowledge

Sector experience is not, as some seem to believe, the answer to everything. For example when the Internet boom was nearing its peak one consultant published a brochure on doing business on the Internet. This consultant's knowledge of the theory of Internet trading, compiled over several years and from many sources, was good. However, when questioned about the more mundane practical issues of interest to prospective backers of these nascent businesses, like how much and how long it takes to construct a website that works, he was next to useless. Even cursory investigation of his output would have shown that its quality hinged not on Internet experience as such but on normal business investigation. In other words, what was important to the due diligence process in this particular industry was no different to that in any other industry. What counted much more than industry knowledge was having the right people asking the right questions of the right sources.

So, if you are one of those who is convinced that industry knowledge is important, it pays to think very carefully about just what experience you are being provided. You should also bear four other things in mind:

1. Consultants can usually 'buy in' industry expertise if it is needed that much.

2. The reality is that there is often no such thing as an 'industry'. Consider the engineering industry. The term 'engineering' covers a tremendous variety of activities from basic industries, such as steel making or forging, through industries with some special features, such as automotive components or aerospace sub- contracting, right up to some fairly high-tech areas like automatic test equipment. It would be naive to believe anyone can be an expert in all aspects of the 'engineering' industry, and the same is true of every other industry.

3. Just because a firm has carried out due diligence before in certain industries does not necessarily make the whole firm an expert on those industries. If the people involved previously do not happen to be involved this time round, where is the industry experience?

4. Industry knowledge can be out of date. A lot of the commercial due diligence one-man bands are what are called 'industry gurus'. Normally these are retired or semi-retired professionals. Some are excellent, but some are not and the trouble with the ones that are

W 0 r kin 9 wi t had vis e r s 35

not is that their knowledge is out of date - even a couple of years away from an industry can be critical - and prone to prejudices and received wisdoms built up over many years.


Although the reputation of the fum is important, the individual qualities of the team are most important. A buyer is going to look to these individuals for good advice in a period of great stress. Above all, advisers should have appropriate experience for the work required. Do not allow due diligence to be pushed down to junior levels unless this is appropriate. Be particularly aware of this if using large firms of accountants for due diligence work. Most of these firms recruit graduates for their audit departments and to give them more challenge and variety often give them the opportunity to work on due diligence projects. Although it might help with their development and retention, it might not always be the best way of servicing clients' needs.

But it is not just accountants that can be guilty of using junior staff. The OTI report into Robert Maxwell's business affairs stated that 'MGN's unsuitability for listing was the result of failures for which Samuel Montagu were responsible to the extent we have identified." According to the Financial Times» some bankers believe that Samuel Montagu's use of inexperienced staff on the Mirror float was at the root of the problem.

Clearly, then, it is important to find out how much involvement the senior adviser will have. All too often he or she will 'sell' the work, then disappear and leave more junior members of staff to complete it. If time permits it is a good idea to meet the adviser's teams and satisfy yourself as to the level of their experience and how they would handle the assignment. You do not want to be lumbered with the B team. In gauging this, remember that carrying out due diligence requires the right people asking the right questions of the right sources. The right people need more than just analytical skills and a good grasp of accounting standards or whatever. Analysis is important, but due diligence also requires a healthy slug of streetwise detective work and a lot of judgement. It is therefore much more suited to advisers who have been round the block, and preferably several different blocks, a few times than it is to intellectuals or newly qualified professionals who have never had to get their hands dirty.


Teams should be kept small. The main objective is an overview of the entire company. The more people working on an assignment, the more the information is dispersed between them. One of the problems with trying to compress timescales means more people are needed to cover the ground in time, but more people can also means less collective understanding.


Many advisers are now making a big play of being able to offer an integrated due diligence service providing financial, legal and commercial expertise plus many of the other disciplines. Their argument is that the end result is better because there is one team working on the transaction. This is stretching the truth ever so very slightly. But that is not the most

36 Due D iii 9 e n c e

important paint. To be sure, buying 'best in class' usually means engaging a number of teams, but it also gives a number of different perspectives on the target, Due diligence is not a precise science. Buyers can benefit from having assessments from as many different perspectives as is practical. Besides, if the person in charge of due diligence is doing his or her job properly, communication and coordination between the various due diligence providers will not be an issue.


Due diligence is a fraught and time-compressed exercise, requiring the maximum expertise pumping out the maximum in usefulness. This is not the time to have to carry any passengers. It is important, therefore, to watch advisers for any danger signs.

Part of the routine is for advisers to ask lots of questions. To an extent this is to be welcomed although a good many will owe more to show than a genuine desire to understand. A failure to ask searching questions is a cause for concern. Either:

• The advisers are not thinking through their approach. Or

• They are going to rely on an 'off the shelf' approach which does not take into account the particular circumstances of your acquisition. Or

• They are that breed of professional adviser conditioned not to admit that they do not know everything.

Advisers may justify their relative lack of imaginative questioning by their emphasis on previous sector experience. Probe just how real it is, especially amongst the individuals who will be working on the project.

Having satisfied yourself that you have not been fobbed off with the B team, watch for team changes. Lack of continuity during the process may mean other assignments are more important to them and junior staff are being assigned to your project. Difficulty contacting senior team members may confirm this, as they may be busy on other projects.

Of course they may just not get to grips with the industry or the issues, in which case they will not be able to talk sensibly about their work as the project unfolds, or they may just not be suitable, in which case they will annoy management and/or customers by applying a process regardless. Advisers need to be aware that every acquisition is different and show sensitivity to the particular situation in which they are working.

Timetables: involve advisers early

A typical due diligence assignment is going to take at least a month. The exact time frame will depend on the scope of work and complexity of the company being investigated. It can be shortened but, if it is, there is a danger that quality will suffer. Putting more people on to a project may allow the ground to be covered and the boxes to be ticked, but it does not guarantee that the analysis of findings will be carried out with enough thought or thoroughness. Analysis takes time and familiarity with all of the findings. If you do not leave the adviser sufficient time, the analysis will not be done properly. In any case, due diligence reports frequently take longer than expected.

The message, therefore, is to give advisers as much time as possible and involve them as

Working with advisers 37

early as possible. Even if the deal has not been finalized it is still worth calling them in. They can begin to plan the work, think about putting a team together and even start some of the background desk research. Many acquirers seem to have the misguided belief that firms of professional advisers have teams of often highly paid employees sitting around on the off chance that a deal may come along. As a result they spend months talking to target management and playing with their spreadsheets, only calling in advisers at the last possible minute.

Involving advisers early also allows you to pick their brains. Very often advisers will have much more due diligence experience so, for example, time spent with advisers thinking through terms of reference in the early stages will be time well spent. It will help you decide what you need, when and from whom. However, do not:

• let the process start until you are sure of wha t you do need

• let the adviser dicta te the scope of the work.

The other side of the coin is that if you involve advisers late, they will charge more - beca use they know they can.

A colleague tells a wonderful stOIY which sums up how not to do it. The written briefing on the work to be done included something like the following,

Timing is tight. There are only two weeks in which to complete the investigation. We require a final presentation by Friday 27 April.

The initial phone call warning him of the deal was not made until Tuesday 17th, and the written briefing did not arrive until the following day, Wednesday 18th. The client wanted a written proposal before giving the go-ahead. That was sent on the Wednesday and approved late morning the following day. Assuming he could drop everything else he was working on, the adviser in question now had, not a 'tight' two-week timetable, but one week plus a day and a half - and he had not even begun to assemble a team. The work was completed on time but the client still had a moan about the relative lack of analysis, that, not surprisingly, the report did not answer all the questions that were included in the original briefing and that the cost was higher this time than it was last time. In this case the client only had himself to blame for not getting exactly what he wanted.

Under the heading of timetable, it pays also to consider the sequence in which due diligence advisers are deployed. The legal and financial teams are probably going to be quite expensive. It is pointless letting them get started if there are still some lingering doubts about the deal. If for example the deal involves a site with potential environmental liabilities you may want to get an interim report from a firm of environmental specialists which gives the site a reasonable bill of health before giving the go-ahead to the other advisers. Many US acquirers will not even brief their advisers until they are satisfied on environmental liabilities. Similarly, some investigations take much longer than others. This may have a bearing on sequencing advisers' work. Intellectual property, for example, can involve a lot of elapsed time, whereas most commercial due diligence investigations are more or less guaranteed to take three weeks.

38 Due D iii 9 e nee

Written terms of reference

Establishing written terms of reference is one of the most important aspects of working with advisers. What you expect each specialist to do, by when and for how much, should be properly reflected in writing. There are a number of obvious reasons for this .. Two others are:

1. You will not wish to pay two or three advisers for investigating the same areas. All too often advisers will duplicate each other's efforts or try to improve on the efforts of another adviser if their respective roles are not properly defined. Tax is a good example. Who do you want to investigate tax? It is an area that could fall into legal or financial due diligence.

2. If due diligence is not properly coordinated, it is quite likely that something will fall between the cracks. The case of Atlantic Computers, below, is a good example of what can go wrong.

The written engagement letter for each adviser will set out:

• The scope of the due diligence work to be carried out. Incomplete scope is often a major obstacle to getting the best out of advisers.

• A clear demarcation of responsibilities, possibly showing how one adviser's brief fits with

other advisers' work.

• To whom the adviser owes a duty of care .

• Their timetable.

• Whether an interim report or presentation is needed.

• Fees.

• Headings to be covered in the report, (Appendix A includes some suggested terms of

reference for various due diligence advtsets.)

• Who will manage the assignment .

• Confidentiality.

• The rights to the results.

• Assignability of the resul ts.

• Liability insurance (if appropriate).

• What happens if the deal is abandoned and the work is terminated early.


Atlantic leased computers with a unique proposal called the 'flex lease'. The flex lease had two elements:

I. A lease agreement (normally for 6 years)

2. A management agreement, between Atlantic and the company taking out the lease, which contained two options:

• A flex option which allowed the leaseholder to take out a new lease for different equipment after three years

• A walk option which allowed the lessee to termina te the lease after five years.

W 0 r kin 9 wi t had vis e r s 39

It was the management agreement which proved the killer. It meant that when the flex or walk options were exercised, Atlantic became responsible for the lessee's obligations under the lease. This in practice meant Atlantic paying the lease founders to discharge the obligations.

Atlantic could also acquire the equipment for a nominal sum at the end of the lease, but this was the 1980s when machines were quickly becoming out of date (which of course explains why the Flexlease was so popular). Not surprisingly, the liabilities Atlantic assumed were greater than the value of the equipment.

At the time B&C (British and Commonwealth) acquired Atlantic it failed to understand the full extent of Atlantic's potential liabilities. They were enough to bring down the group. The situation arose because of confusion over the role of B&C's professional advisers .. No formal written instructions were given to merchant bankers to define their role in the acquisition, nor was it clear whether the specialist consultants, who had been instructed to conduct an independent investigation into Atlantic and the computer leasing industry, were the clients of B&C or the merchan t bank. The merchan t bank had not considered it wi thin its mandate to investigate and subsequently advise upon the flex lease arrangements (they saw themselves as facilitators and coordinators) whereas B&C claimed their role was to assist and advise in the evaluation of Atlantic's business and its suitability for acquisition.

Al! this meant that although the consultants pointed out the high risks involved in computer leasing in general, and Atlantic's particularly high risks under Flexlease, the message somehow never got through. The DTI inspectors concluded that the resulting confusion over roles and reporting lines was a factor contributing towards B&C's failure to gain an adequate understanding of Atlantic's business prior to the takeover.

The Atlantic case is a clear example of why it is crucial that each area of due diligence is outlined in detail and clear, written instructions given to the relevant advisers. It also reinforces the message that advisers should be encouraged to work together and to share information properly.


Generally speaking, you get what you pay for in due diligence. You can have a cheap report or you can have a good report, but not both. Advisers will tell you that fees tend to be competitive and, in any case, the choice of consultant should not be overly cost-driven, They will maintain that the reputation and experience standing behind opinions are more important than simple fee considerations. To an extent they are right, but a firm of advisers is always going to charge what it thinks it can get away with. If it sees the prospective buyer as someone wi th deep pockets or too inexperienced to know any better, the proposed fee will be higher than if it thinks it is dealing with a mean and experienced acquirer, It is worth haggling and talking with people in other companies who have recently done deals to find out what sort of fees they paid (and whether they thought them reasonable). Do not be frightened of picking up the phone and talking to other companies who have been on the acquisition trail. There is almost a spirit of 'us' and 'them' as far as advisers are concerned and this brings with it a certain camaraderie and a willingness to help.

It is normal for due diligence to be carried out on the basis of a fixed fee. Of course it is extremely difficult to estimate how many hours a due diligence exercise will consume. It is really up to advisers to get their estimates right and a buyer should be reluctant to vary fee

40 Due D iii 9 e n c e

levels unless there is a change in the scope of work or delays outside the adviser's control. In the event of either of these, it is up to the adviser to convince the buyer of the need for additional fees.

Contingent fees are becoming increasingly common. Here the exact fee charged depends on whether or not the deal completes. The usual arrangement is for there to be a discount on the fee if the deal does not go ahead and an uplift if it does. How much the fee varies around the 'normal' is really up to the adviser and the buyer to negotiate. Contingent fee arrangements can vary from a small up/down right through to 100 per cent success fees (that is nothing if the deal does not complete but a considerable uplift if it does).

Although contingent fees are a good way to minimize costs if a deal does not go ahead, they do give the adviser a vested interested in producing a positive report and this provides a clear conflict of interest. In the words of a very experienced deal doer,

I wonder how dearly people work in situations where they make half a million if the deal happens and get nothing if they tell me about a minor defect."

On balance it is probably better to avoid fee arrangements which give advisers too much of a material interest in the transaction taking place, particularly in the light of tales such as the following,

I was called by the lawyers on the other side. 'We have £400,000 on the dock,' they told me, 'and we're on a success fee. So if you really insist on these warranties, we'll make sure you're satisfied. I]

The fairest mechanism is one which at least allows the advisers to eat if the deal does not go ahead but gives them a reward if it does. As a rough rule of thumb, one-third of the price of a due diligence exercise win be profit. On a contingent fee basis this would mean knocking off a third of the fee if the deal aborts and adding up to the same again on to the 'normal' price if it completes. On this basis, for a £60000 exercise, the high/low fee would be £40000 abort and up to £80000 success.

Sometimes advisers are paid on a success fee only basis where the fee is a percentage of the transaction. Not only does this give advisers a huge vested interest in the deal going ahead, but there is something not quite right about advisers getting more if they get the acquirer to pay more for the target. There are ways round this, though, like advisers being paid a bonus based on savings below a ceiling target price.


Some advisers seek to cap their liability. Liability caps seek to limit the extent of an adviser's liability should the client succeed in establishing that it has been negligent. The basis of these liability caps varies between firms and indeed not all firms try to impose them, Typically they are linked to a monetary value. For example, the standard accountants' cap is the lower of £25 million or 1 per cent of the deal

Liability caps are hard to justify. If the job is done properly, the adviser has nothing to worry about. At the very least the prospective client is owed a full explanation of why advisers deem it necessary to cap their liabilities, If buyers are not satisfied, they should say so and perhaps go elsewhere.

Working with advisers 41

Advisers will try to justify liability caps because from their perspective there is always a risk of allegations of professional negligence if things go wrong. The test at law is what a reasonable professional would have done in the circumstances. This does not support the argument for liability caps. What it does support is the importance of advisers agreeing the extent of the due diligence work at the outset, setting out in formal letters of engagement what is expected and then doing a good job.

If the target's auditors are being used, they will attempt to slip a clause into their terms of reference which gives them an indemnity in res pect of their audit work. This definitely needs taking out.

Plan the work

If establishing sensible terms of reference is the most important contribution to successful due diligence, probably the next most important is to plan how the work is going to be carried out.

Much due diligence involves analysing information supplied by the target company and interviewing members of its management team. In order to ensure that time is not wasted and that the information and people are available, it is vital to plan the work in conjunction with the management of the target company. There is little paint in teams of expensive advisers arriving at a company only to find that the key people are not available or that it will take time to provide the information that they require.

It is therefore vital in planning the work that the target is supplied early on with detailed lists of information requirements and the people to be interviewed. Whilst more information and more interviews will normally be required during the course of the work, this initial planning should greatly help ensure that the work is carried out efficiently.


Exactly who does the coordination depends on company style and the deal in question. In small and medium-sized companies, masterminding an acquisition may fall to the chief executive. In larger companies it may be the manager of the division which will be responsible for running the company after it is bought, or it may be an individual or a department which has responsibility for carrying out acquisitions.

There are advantages and disadvantages to each approach. If the business unit which will run the acquisition handles the deal more sector understanding may be brought to bear in the research and negotiation processes. If, on the other hand, acquisition specialists do the work, they can build on the experience of previous deals. There is a lot to remember during an acquisi tion and there is no doubt that practice makes, if not perfect, then improvements.

The preferred route is certainly to involve the operators fully at an early stage. Chapter 1 stresses the importance of thinking about the integration plan right from the very start. The only other rule is to have someone who is responsible for running the entire due diligence and who therefore sees the whole picture.

If coordination is not done by one of the buyer's personnel (which ideally it should), one adviser should be appointed to coordinate the due diligence (ideally the adviser who is closest to the commercial negotiations).

42 Due D iii 9 e n c e

Coordination is also necessary with various in-house experts.

• What are the objectives and concerns of the line managers who either know the business or are going to have to run it afterwards? Are there any particular areas of concern or sensitivity both in terms of confidentiality and in terms of known problems?

• Internally who ate the main points of contact? Who has authority for what? What are the main areas of responsibility?

• Internal advisers (tax, property and so on) may have excellent knowledge which can be applied to the target business. How are they to be used?

• Will the project manager act as the main interface between the internal experts, the commercial team and outside advisers, or will the outside advisers have direct access?

Communicate regularly

Whoever is coordinating due diligence should make sure there is regular communication with the advisers. Communication should not be a one-off event which takes place when the finished report is presented (or, more likely, when the executive summaries are circulated to management). This is not to say that there should be formal progress meetings on a weekly basis, the deal timetable is usually too short for that, but there should be reasonably regular updates from external advisers as the enquiries proceed. If nothing else, this allows the buyer to:

• communicate changes in its concerns

• identify Significant issues early on

• make sure all advisers' efforts are coordinated

Also hold regular meetings internally so that:

• The commercial impact of what is being found out can be properly assessed, questions can be raised and fed back to the investigating advisers and areas where further investigation is needed can be identified. There may be issues which kill the deal and the sooner these are brought up, the better.

• The due diligence process itself can be evaluated. Are you getting what you want out of the process?

Code names

It is a very useful discipline to insist that all parties to the proposed sale use agreed code names. Very often code names can help protect the identity of the parties and the target company should any sensitive correspondence or other written material fall into the wrong hands.


The form of report is also an important key to managing the process effectively. A buyer will want a written report. This is not just a record but fulfils several functions such as keeping all

W 0 r kin 9 wi t had vis e r s 43

parties informed of matters ansmg. There is also much to be said for insisting on a presentation. This is the opportunity to pin advisers down as to what they really think and to watch them wince when asked for their assessment of the risks involved. Whether written, verbal or both, above all advisers must give opinions. Buyers must insist on getting opinions. The advisers are the experts, they have trawled through the detail, and they should be capable of giving an opinion.

Due diligence reports should be user-friendly and contain an executive summary. The executive summary is the most important chapter as this is the only part many recipients will actually read. Reports should be written in easy to understand, non-technical language. Lawyers, for example, tend to write in a form only other lawyers can understand. You should guard against reports becoming huge tomes without too much form or meaty content. It is not unknown for external advisers to get lost in detail and lose sigh t of the deal as a whole. Be clear from the outset about what you want and how much you want. It could be three bullets or 300 pages. You might even consider using a standard format. You will almost certainly want to 'audit' the reports before they are circulated. If you cannot understand what is being said there is a good chance no one else will either. It is also an opportunity to pull out parts tha t may be relevant for other ad visers to review.

Finally, there is no point shooting the messenger. If a due diligence report comes back full of negative sentiments about the business, the deal may not be worth doing in spite of the amount of shoe leather that has gone into getting it this far. Unless they have totally misunderstood the target company and/or its market, it is not the advisers' fault. One investigation into a mature, but relatively fragmented industry revealed that stalemate in Europe meant that the buyer would not be able to put up prices post-acquisition if it did the deaL The reasons were quite clear:

• The combination of the buyer and the target would make it only marginally bigger than the other four competitors in Europe. The acquisition would not give the buyer sufficient clout in Europe to influence prices .

• Even if the acquisition gave the target sufficient clout in theory, in practice the target and the buyer com peted in different segm en ts of the rna rket,

• Most big customers were now sourcing globally, based on price. Price rises would therefore be difficult to achieve, even with scale.

Although based on a very extensive European due diligence programme, these were not popular findings with local management who proceeded to whine and nit-pick, rather than revisit their original deal price assumptions.

Post-acquisition due diligence

As mentioned in Chapter 1, what normally happens post-deal is that the acquisition team moves on to the next project and another group of people come in to manage the newly acquired target. However, when a lot of experience, expense and late nights have gone into negotiating the deal and the legal protection around it, it is wasteful not to have a mechanism for identifying possible warranty and indemnity claims which may come to light after completion. It is best to make someone responsible for this and ensure that operating management understands that it is possible to claim certain things from the seller.

44 Due D iii 9 e n c e

They will need to be fully briefed on time limits for claims and to understand the claims proced ure. The sta tutory Iimita tion period for notifying warranty and indemnity claims is six years or 12 years from the sale. Negotiated limitation periods can be as low as two years. Sale and purchase agreements often contain formal notification procedures for dealing with warranty and indemnity claims. It goes without saying that these need to be complied with.


A due diligence programme is likely to involve a number of different advisers. Even when the target is a business the acquirer knows well, perhaps competing in the same industry and sharing the same distributors, external advice can add a lot of value to a transaction. How much value they add will be heavily influenced by how well due diligence is managed. Planning, coordination and communication are as important as any other input and project management should be given top priority.

It may be an obvious point but advisers cannot be expected to perform to their full potential if they are not properly briefed, do not understand the brief, or are not kept informed of relevant findings of other advisers. If in doubt, over-communicate.

Getting the best out of advisers also means using the right ones. A mix of technical ability, chemistry, due diligence experience, possibly sector experience, fee levels and the degree of involvement by senior professionals will all be factors in the final choice. One thing is certain, you will not have time to get to know advisers in the heat of a deal so get to know them and select them before the pressure is on. Then you can involve them at the earliest possible stage.

Finally, you will need a user-friendly written report with an executive summary and opinions and a presentation which gives you the chance to probe the advisers and their findings.

CHAPTER 4 Financial due diligence

Very few deals are carried out without financial due diligence. Scandals such as Enron make it unlikely that its importance wiLl diminish. There is, however, a lot more to financial due diligence than examining accounting policies or information systems. Good financial due diligence aims to give a view of underlying profit which can be used, if not to predict the future, then to provide a canvas on which the picture of the future can be painted. It also pays to remember that reporting accountants are well-trained business professionals who are going to spend a lot of time in the target company. They can be an extremely good source of other, non-financial, business information about the target.

As most companies produce audited accounts it might seem a little surprising that so much time, effort, angst and expense is devoted to financial due diligence (POD). There are two reasons.

Firs t, contrary to popular belief, accounting is not a science. This means that even a udi ted accounts contain many uncertainties as far as the purchaser is concerned:

• All accounts are subject to a number of judgements. Some, such as the valuation of stock and depreciation policies, can make a big difference to reported profitability. Also the time when income is recognized can vary depending on accounting policies or judgements. As a result trends in profits can be distorted.

• Accounts will probably contain a number of 'one-off' profits or expenses which distort the profitability of the business and which need to be found and removed from the numbers.

So one of the main roles of reporting accountants is to undo what has been done by other accoun tan ts.

Second, generally speaking in English law, a purchaser will not be able to rely on audited accounts. You would be very wrong if you thought that audited accounts are prepared by independent experts to reassure the outside world on the state of a limited company's finances. Apparently, they are not part of the price of limited liability, there to give information to anybody doing business with the company so they can have some idea of the risk they are taking. Audited accounts most definitely cannot be relied upon. Auditors are not responsible to shareholders, credi tors or anyone else who deals with a com pany. They cannot be held liable in negligence if they fail to prepare or audit financial statements with due care and skill.

The case of Caparo Industries v Dickman established all of the above. The case went as follows. A UK listed company called Fidelity issued a profits warning in March 1984. Fidelity's share price fell sharply. In May the (unqualified) audited accounts were issued and the directors announced that profits were lower than had earlier been predicted. On 8 June Caparo began to acquire Fidelity's shares. By 6 July it had bought 29.9 per cent of Fidelity's issued share capital and in September it mounted a full bid which was successful.

46 Due D iii 9 e nee

Caparo subsequently alleged that Fidelity's accounts were inaccurate and misleading. It was suggested, for example, that stock was overvalued and that credit notes due to customers had been understated. The aUeged effect was that the accounts should have recorded a loss of around £400 000 whereas in fact they reported a profit of £1.3 million,

Audited accounts had been sent to shareholders on I3 June. Caparo was a shareholder by that time and claimed that its share purchases made after 13 June were based on those (inaccurate) accounts. It claimed that had it known of Fidelity's true position it would not have purchased those shares nor would it have made the eventual bid at the price paid, if at all. It suggested that the auditors should have been aware that Fidelity was vulnerable to a bid following the fall in Fidelity's share price after the March profits warning, that any potential bidder would be likely to rely on the accounts when assessing a bid and that a bidder would suffer a loss if the accounts were inaccurate.

The general rules of the law of tort would look at foreseeability, proximity and fairness before giving a ruling on whether an auditor owes a duty of care to people who rely on negligently audited financial statements. Caparo had proximity. (It was a shareholder.) It argued foreseeability. (Many a company has been taken over following a profits warning and as anybody with even a passing knowledge of how the City really works would know the profits warning would lead to potential bidders taking a closer interest in Fidelity. The first thing they would do is turn to the latest audited accounts.) It probably also had fairness on its side. It would not have paid as much for the bulk of its shareholding if it had known that the accounts were overstating profits by some £1.7 million.

The Court of Appeal and the House of Lords ruled that not only is there no duty of care between an auditor and potential investors in a company, but there is not even a duty of care to existing shareholders. Apparently, (according to Lord Oliver) an auditor's report is not issued for 'the purposes of individual speculation with a view to profit'.


Until a firm offer is made, the vendor will have controlled information. Anything provided will inevitably have presented the target company in its best light. The would-be purchaser will probably have based its offer on a multiple of last year's profit and will have made a number of assumptions, for example:

• The future performance of the business will be similar to the past.

• The relationships with customers are strong and this will continue.

• Margins are not under pressure.

• Accounting policies have been consistent and reasonably applied.

• There are no looming liabilities such as significantly higher maintenance costs.

This is the acquirer's opportunity to satisfy itself on the assumptions made, not just about the target but also about how well the target fits the buyer's acquisition strategy and the deliverability of its synergy assumptions. It is also the only opportunity a buyer will get to make sure there are no skeletons in the cupboard big enough to break the deal. It presents the ideal opportunity to find as many smaller skeletons as possible with which to negotiate a price reduction. FDD will be important in determining the net debt position at completion and therefore any ramifications for price clauses in the contract. It can also help in

Fin an cia I due d iii 9 e n c e 47

structuring the transaction. It may identify some pretty uncertain liabilities which end up being left with the seller. I t may identify tha t tax efficiency is best achieved by lea vmg debt in the business or that tax losses can be used by acquiring the company rather than assets.

But financial due diligence goes one step further than purely transaction-related enquiries. Its real aim is to look behind the information provided by the target company and assist the acquirer in forming a view on underlying profitability. This will provide the basis for forecasting future performance.

The fundamental building blocks of financial due diligence are therefore strikingly similar to those in the other due diligence disciplines. These can be summarized as:

• Verifying the numbers on which the offer is based

• Identifying any deal breakers

• Providing ammunition for the negotiations/identifying where warranties or indemnities are needed

• Giving confidence in the underlying performance, and therefore future profits.


Deal breakers or items for which warranties/indemnities may be needed include:

• Over/under valuation of assets and liabilities

• Adequacy of provisions

• Potential black holes, for example pensions under-funding.


Under the heading of helping to shift the balance of negotiating power would come:

• Highlighting risks

• Highlighting liabilities

• Challenging forecasts

• Challenging accounting treatments

• Down-rating past performance.


Maintainable profit is the underlying profit which the target company is capable of earning. There is no particular magic to the concept but it is much more than taking historical profits and stripping out any 'abnormal' items - although this will be the starting point because underlying profit can be masked by such things as;

• Group and other management charges and expenses

• Owner expenses

• Transfers of business

• Reorganization provisions

• Transfer pricing

• One-off expenditure

48 Due D iii 9 e n c e

• Sale of fixed assets

• Pension accounting

• Insurance claims

• Stock write-offs

• Changes in accounting practices, policies and procedures.

Underlying profit is about understanding the business. It is not a simple, mechanistic, feat of number crunching after working through the target's books. It means making an assessment of the means by which profits are generated, which in tum means understanding the market, customers, production, suppliers and management and identifying factors key to the success of the business. Of course, it is quite possible that the numbers have been cobbled together or achieved more by luck than skill. For these reasons it is also an important function of financial due diligence to review:

• The reliability of the systems generating those profits

• Budgets and projections and the assumptions underpinning them

• The numerical integrity of the budgets and forecasts

• The adeq uacy of the assum ptions underlying them.

Financial due diligence is not the same as an audit

If all the above sounds like what the auditors do once a year, it is not. FDD will not delve into the numbers. Instead it says what the numbers are and why they are what they are. The accountants' engagement letter will probably state quite categorically that financial due diligence and audit are quite distinct. It will have a clause like,

Our procedures in preparing the presentation and report will not comprise an audit and we will not be in a position to express a formal opinion on the financial information which we will be reviewing.'

The differences are summarized in Table 4.1. The aim of an audit is to verify results. Due diligence seeks to explain results. It begins with information supplied by the company and supports this by interviewing key members of the management team and by reviewing the auditors' working papers. It takes reported results and arrives at underlying profitability after isolating exceptional income and costs. It does not normally involve the independent verification of financial information by checking it to source documents. Inevitably FDD uses a lot more 'soft' issues than an audit.

The financial due diligence team will try to speak to the auditors and review the audit files for the last two to three years and, if they are also looking at tax, the tax files for up to the last six years. They will do this at an early stage of the investigation, not to get 'the answer', although there is an element of that, but to try to get a picture of how thoroughly the numbers have been scrutinized. The amount of audit scrutiny can vary enormously. Reviewing audit files is a good starting point, but it is not a substitute for access to the target.

Fin a n cia I due d iii 9 e nee 49

Table 4.1 The differences between audit and financial due diligence


Financial due diligence


Verify results and present a 'true and fair' picture

Establish underlying profit

Flush out 'black holes' and negotiating issues



Independent verification of numbers to give assurance as to the reliabi'lity of historical financial information

Past and future

Understand why the results are what they are Focus on key drivers of a business


Defined by statute and regulation

Often limited just to key issues


U nrest.ricted

Might be restricted


Substantive and compliance testing


Hold harmless letters

Although giving access to audit papers is something of a professional courtesy, the auditors will lay down a number of conditions. They do this in the form of a letter asking as a minimum, for:

• An indemnity from the acquirer against any legal action which may come their way as a result of allowing access to the audit working papers

• Confirmation from the investigating accountants that nothing can be relted upon and that everything will be kept confidential.

They might also insist on a number of other conditions some of which are sometimes completely over the top and should be resisted if at all possible. However, they have the po. pers and if the deal goes ahead they are probably going to lose an audit client. There is li ttle incentive for them to cooperate and every risk if they do. If they lay down the law on indemnity a buyer, and an investigating accountant who wants to see those papers, usually has little choice but to accept. Whether a protracted fight is worth the effort is another question because reviewing audit papers is not that important to the investigation.

Terms of reference

I f you lack a cure for insom nia, spend as little time as you possibly can on terms of reference. Often the reason why financial due diligence reports are long and boring is that the accountants have not been told what is of real importance, or they have been told and failed to understand. The blame for this can lie on both sides, but you, the commissioner of financial due diligence, should recognize that you reap what you sow. Time spent with the reporting accountants thinking through terms of reference in the early stages will be time well spent. This, remember, is going to be carried out by people who trained as auditors. An audit is very prescriptive. In contrast, there is very little guidance from the profession on

50 Due D iii 9 e n c e

non-audit investigations such as financial due diligence. They have to be told what to do so you must be clear in your own mind:

• what must be confirmed

• what must not be true

for the deal to go ahead. Only then can the purchaser and the reporting accountant agree a scope which tests the purchaser's preconceptions of the target company. Until you are absolutely sure what you need, do not let the process start.

Another key is for the reporting accountants to understand the full context in which their report is being prepared. For example if the report is on a company which is being acquired, the reporting accountant should seek to understand the purchaser's acquisition strategy and why it is planning to make the acquisition in question. If it is to gain market share but fold all operations into the acquirer's existing facilities, the investigation will have a different focus than if it is to enter a new geographical market and keep the acqulred operation running.


The most common type of due diligence report is a detailed written report, known as a Long Form Report, covering almost all aspects of a business. The Long Form Report may be exactly what you want at the end of the financial due diligence exercise. However, remember that communication should not be a one-off event. You must communicate regularly with advisers and not wait for the finished tome to arrive.

The areas typically covered by a Long Form Report are described in detail in the Topics section below, but the important point to note at this stage is that a Long Form Report provides a profile of the whole business, not just the financial aspects of it.

It need not always be so all-embracing. The terms of reference for a report commissioned by a sponsor prior to a flotation or by a private equity investor will be immensely detailed. In these circumstances the sponsor or investor will be trying to protect itself by ensuring that there is almost no limitation on the scope of the report. The resulting reports are therefore legitimately very long and can seem unfocused because of the sweeping nature of the instructions.

In contrast an acquirer of a business, or a bank which has an existing relationship with a company, will very often provide a much tighter brief, asking the accountant solely to focus on those areas which are of particular importance to them. As already mentioned in Chapter 3, it is a good idea in these circumstances for the buyer to work with the accountants, who will often have more experience of financial due diligence enquiries, to establish an appropriate brief. If after starting the assignment it becomes apparent that the scope of work needs to be extended, an extension of the scope can al ways be negotiated.

Clearly, financial investigation reports which are prepared on the basis of a more focused brief will be much shorter documents than the traditional Long Form Report described above. However, these reports should not be confused with Short Form Accountants' Report. This term is normally used only to describe the summary audited accounts contained within a prospectus and not short due diligence reports.

Facts and opinions given by individuals are usually attributed to that person in the

Financial due diligence 51

report. A draft of the report, excluding conclusions and recommendations, will usually be given to the directors of the target and they will be asked to confirm in writing the factual accuracy of the report. From a negotiating point of view, however, this may not always be a good idea. If, for example, there is a very conservative policy on, say, warranties that suggest provisions should be released the buyer will not want to tell this to the seller. Make sure the reporting accoun tant is aware of the plan ned negotiating tactics.

The approach to financial due diligence

Financial due diligence involves detailed analysis of a business supported by interviews with the key people in the business. It is worth emphasizing again that the approach to due diligence is quite different from that adopted in an audit. Experienced practitioners would say that the more the investigating accountant gets around, asks questions and sees questions through until receiving a satisfactory answer, the better. It stands to reason that if the purpose of financial due diligence is to explain why the numbers are what they are, the investigator should be more concerned with finding and getting to the bottom of anything that looks strange than with crunching numbers given by the target.

Cross-border considera tions

Local advice is key. Financial statements may look very similar but despite various directives on company accounts, and more of a willingness to adopt international standards, there remain considerable differences between the accounting policies employed around the world. There are also considerable philosophical differences. In many countries taxation is the dominant influence on the preparation of accounts. This means that, for example, depreciation rates may reflect more what the tax authorities want than what is economically appropriate for the business. In the UK, substance over form is a fundamental premise in financial reporting. As the Enron scandal showed, the approach in the US can be quite different as it is in, for example, France where they take a more legalistic approach.

The quality of management information will vary by country. Some countries are prone to producing large volumes of information, sometimes with little concern about its utility for running the business: in other countries even monthly management accounts are unknown.

Because of the lack of effective harmonization, the analysis of financials can be a long and drawn -out affair if the target has operations in a number of different countries. This will need to be factored into the due diligence timetable. But the thing to remember, always, is not to get carried away with the technical or interesting. The FDD objectives are the same whatever the country and that is to get to a proper understanding of the target's ability to make profits in the future.

Choosing the team

In most cases financial due diligence is carried out by firms of accountants. More often than not, the investigating team will be drawn from the purchaser's auditors, but there are no firm rules about this. There are a number of advantages in using the auditors. Chief amongst them

52 Due D iii 9 e n c e

is that it usually makes the finance director comfortable. Auditors usually have the manpower and expertise to carry out financial due diligence and they will know quite a lot about the client and its strategy. The important thing to remember is that financial due diligence is not the same as an audit. It involves a lot more uncertainty and calls for a great deal more judgement than an audit and as such may call for a different type of accountant.

The work

Financial due diligence work relies heavily on the target company for information and especially on interviews with its management team. The FDD team therefore needs to plan the work in conjunction with the target. Investigating accountants need the key people to be available and information they require to be on hand.

It is therefore vital that in planning the work the investigating accountants supply the target company with a detailed list of their information requirements and the people they will wish to see, which is why the process will usually kick off with an information request (see Appendix A2l.

The accountants will then start their interview programme. The first port of call will rarely be the finance team. First they should speak to those who are responsible for the company's commercial operations. An understanding of the company's history, strategy, competitive environment, purchasing and sales, marketing and production operations is essential. A proper understanding of the business leads to a much more meaningful interpretation of its financial results. Even if the brief does not call for long 'history' and 'business strategy and activities' sections it is still worthwhile for the investigating accountants to cover these areas.

The main operating locations of the company will also be visited at an early stage so that the reporting accountant gets an understanding of the operating and cultural environment of the target.

Reviewing working papers should be another early activity although because auditors often try to include some extremely stringent clauses in hold harmless letters, it is not always as early as it should be. Working papers should provide a good overview of the financial control and management information systems of a company, together with an understanding of any key judgements arrived at in preparing the audited financial statements.

Next will come a review of financial information provided by the target: management and statutory accounts, managing directors' reports, business plans, budgets, forecasts and so on. The heart of the work is the analysis of the numbers provided by the target and above all interviews to expand on and clarify them. The best reporting accountants do their homework before the interviews, keep detailed interview notes, probe the answers given, check them by speaking to other people and make sure that they are consistent with the results of the business. Very often inconsistencies will emerge after asking different people the same question or through analysis of the records. It is therefore essential that the door is left open for follow-up discussions.

Financial due diligence 53

Topics covered in a Long Form Report

The following is a comprehensive list of what could be included in a Long Form Report. How many are covered and to wha t depth will depend on the specifics of the transaction.


This section is really a run-in to the rest of the report. The questions it addresses will include:

• Origin of the business

• Principal events in the last ten years such as changes in ownership, products and services, management and competition


This section describes how the company is organized and run:

• Share Capital and Ownership

• Nature of share capital, details of shareholders, rights attaching to different classes of shares together with options and warrants

• Legal structure

• Explanation of group structure, details of share capital for main subsidiaries and any minority interest

• Management structure

Much of the factual information here overlaps with legal information. Let the lawyers report on the facts. The advantage the accountants can add from their management interviews is to paint a picture of how the target really works. Changes in management and shareholdings can happen for perfectly understandable reasons. They can also happen because the majority shareholder is a total megalomaniac with whom nobody can work. If your intention is to integrate the business with yours and have him run the combined operation, you might like to know how he really operates. Similarly, entrepreneurial companies are often reliant on one charismatic leader. You know an entrepreneur will not stay for long once the deal is done, but do you know what you need to do to make up for his or her departure? Without knowing just how dependent the target is on one individual the answer is 'no'. Again the accoun tants will gi ve a view. Of course you do not need accountan ts to do this bu t as they are likely to spend a good deal of time on site and speak to most of the management, they do make good spies.


The aim of this section is to provide an understanding of what the business does, and of its strategy. It covers a wide range of different areas and is as much concerned with evaluation and opinion as it is with fact-finding. The section will include:

• An overview of the company's strategy. The investigating accountant will not only describe the strategy, for example, but will also want to know who is involved in its setting and how often it is reviewed.

54 Due D iii 9 e nee

Table 4.2 An example of a business overview

Inputs FacWties Sales Markets
2001 110 000 square feet 2001 2001
manufacturing facility in £000 fOOO
Material 3824 Alton (freehold)
Big Trucks Road Transport 58%
Su bcontractors 887 109 direct shopfloor Limited 6990
Direct labour 1736 employees Refri 9 era ti on 36%
4 sales staff Refrigerated
Direct costs 6447 Panels Pic 4411 Commercial
64 administrat.ive staff Fabrication 6%
Production Bespoke Toilets 697
overheads 3492 Activities
Admin overheads 930 Others 52
Laminating plastic
Distri bution 161 sheeting 12150
Marketing 445 Bonding plastics to ply
Total recurring Proofing completed
costs 11475 wood/plastic sections • An overview of the business. Table 4.2 is an example of how an overview might be presented.


Ideally, in this section there should be as much emphasis on analysis, market dynamics and market drivers as there is on fact-finding. FDD will collect information mainly from management. Many of the headings below may well be the subject of commercial due diligence which will collect information from outside the company This means that with a properly managed programme a buyer can get valuable insights on the most important topics from two completely different sources. FDD headings would include:

• Sales and gross profit by activity and geography

• Overall trends in sales or gross margins with a brief explanation. (The detailed analysis will

be given in the Trading Performance review below.)

• Trends in market sizes, shares and growth

• Competitors

• Competitor positioning vis-a-vis the target

• The sustainability of sales and margin in each area of activity and in each geographical


• Proposed new products and markets

• Barriers to entry for new competitors

• Threats and opportunities

Fin an cia I due d iii 9 e nee 55


The aim here is mainly to probe for vulnerabilities. A heavy dependence on a few customers or long-term contracts can be an obvious cause for concern, as could any long-term agency agreements if the acquirer is planning to integrate the business. Customer dissatisfaction is another obvious area to probe. Credit notes, unpaid bills, invoice disputes and warranty claims can all be evidence of something fundamentally wrong with the business and its inability to main tain mar ket share going forward. Related interviews, say to probe the level of salesforce motivation, may well confirm that customers are voting with their feet. On the other hand special discounting or an exceptional level of advertising/promotion may have massaged recent business performance.

A commercial due diligence exercise once revealed how a business had ramped up its advertising in the months prior to sale. During the sale process the seller claimed there was a lot of potential in the business which could be realized with a good advertising campaign. The truth was quite different. The pre-sale advertising campaign had in fact little effect on sales which was why the owner had put the business up for sale in the first place.

Areas for investigation include:

1. Customer base ~ profile, dependency on major customers

2. Analysis of sales and gross profit by major customers/customer groups over the previous

three to five years

3. Extent of customer dependencies/major contracts

4. Customers by geographic region, industry type and any other appropriate criteria

5. Stability, reliability and sustainability of major customers/customer groups

6. Strategies for:

• Marketing

• Pricing ~ leader or follower. how often prices reviewed, ability to flex

• Sales

• Advertising

• Distribution

7. Organization of the sales and marketing functions

8. Details of selling methods including incentive schemes and the use of agents

9. Standard terms (discounts, credit terms, warranty)

10. Seasonality of sales

11. Effectiveness of the sales and marketing function


Underlying profit could be severely affected in a business where there are unstable input prices, a dependency on a few suppliers, frequent supply disruptions and no alternative supply sources. The picture could be worsened by volume rebates which have been recognized in the management accounts but are not in fact earned and forward purchase contracts made just as raw material prices peaked. The review of purchasing and supplies would include the following headings:

• An assessment of the effectiveness of the buying department

56 Due D iii 9 e n c e

• Organization and control of the purchasing

• Principal raw materials

• Key suppliers

• Supplier reliability

• Ra t1 ng versus the al terna tives

• Supplier relationships: any disputes?

• Extent of dependence on suppliers

• Terms of trade - payment, contracts, returns, lead times

• Price volatility

• Quality control procedures

• Procedures for receiving, storing and issuing stock

• Are warehousing facilities suitable and adequate?


Production management is about solving problems. Investigating accountants wiII always find plenty of problems to write about. Their focus, however, should be on the future. Are there any constraints on capacity? Is a costly overhaul going to be needed in the near future? How well do production facilities compare with those of the competition? Are lead times under control and on a par with industry standards? Do research and production work effectively together? A full due diligence report would report under the following headings:

I. Key production processes and how they are organized

2. Production statistics, lead times and quality control

3. Main items of plant and equipment, age and serviceability

4. Competitiveness of the company's production capabilities in its main areas of activity S. Capacity/growth issues. Potential bottlenecks

6. Review of planned capital expenditure

7. Impact of new technologies

8. Stockholding policy

9. Subcontracting arrangements

10. Research and development, an explanation of what R&D is carried out

• Is it properly controlled?

• Is it adequate to maintain the future growth?


These days, book values and valuations of premises tend to be in line, but you never know. Dilapidations and environmental problems could be a concern for future profits, as could any expenditure needed to meet business plans. Under the heading of premises, the investigating accountant would include the following:

• List of leasehold/freehold premises

• Planned disposals/redevelopments

• Adequacy to meet growth plans

• Recent valuations

• Dilapldations

Financial due diligence 57


This section is not only about collecting facts, and explaining and commenting on organization structure, reporting lines and so on. A valuable by-product of FDD, which should always be requested, is the accountants' view on the management team. After all, having spent a number of weeks in close proximity to management, and having interviewed them extensively, the FDD team should be better placed than most to comment on management's strengths and weaknesses. Accountants also need to take a view on the impact of other human resources issues that can be factored into past and future profitability. The acquirer will want to know whether it is buying a business from a 'fat cat' management which is overstaffed by people paid well over the going rate. There will be softer, nonfinancial issues too which need to be explained and commented on. High staff turnover and low staff morale are usually symptoms of wider problems in a business, as could be the recent loss of good staff. Labour shortages may make it impossible to achieve planned growth.

Many of the headings below may be the subject of a more in-depth human resources due diligence and the topics are treated more fully in Chapter 7. Typical financial due diligence report financial headings would include:

• Organization chart with comment on any gaps or imbalances

• Overall culture and management style

• Details of directors and management, length of service, responsibilities, other interests, analysis of service contracts, pension and benefit entitlements. Any changes in senior management in the period under review. Any proposed changes. Assessment of management's strengths and weaknesses. Dependence of the company on key individuals, succession plans/policies, compliance with Cadbury and Greenbury

• Employees. Analyse employees between different areas of the business and different functions. Full-time versus part-time. Detail on union arrangements, staff turnover, remuneration policies, pensions, frequency of pay reviews, date of next/last pay review, terms and conditions of employment, use of temporary or part-time employees, recruitment plans, skill shortages, Recruitment and training poltctes, unfair dismissal or other claims. Assess the strength of the human resource management of the business and the extent to which its workforce provides a competitive advantage to the business.


This section analyses and assesses the key elements of the accounting and management information systems. It is fundamental to the whole financial due diligence exercise not just because of the effect the reliability, or otherwise, of the information can have, but also because of the impact accounting policies and their interpretation can have on reported profits. The target's ability to produce timely and accurate monthly management accounts is one indicator of how well-managed the target is and whether it has its house in order. Report headings would generally include the topics that follow.

Accounting policies and practices

Not only will different accounting policies mean two identical businesses may report very different results, different interpretation of those poltctes can playa major part too. The FDD team must, therefore, not only be on the lookout for changes in policy but, easier said than done, also be looking for changes in the application of those policies. The potential for

58 Due D iii 9 e nee

'flexible' reporting is picked up in the next section which looks at some of the profit and balance sheet manipulations commonly encountered. Consistency and comparability may be even more difficult in cross-border transactions where differences of definition can also play their part in clouding the numbers. Typically an FDD team will report on the following:

• A summary of accounting policies and treatments-

• Whether the accounting policies and treatments comply with generally accepted accounting standards

• An explanation of any that ate unacceptable

• Whether, and to what extent, accounting policies and treatments are consistent with the policies adopted by the purchaser

• Whether accounting policies and treatments been applied consistently during the period under review

Man ag em ent inform a tion

The accountants are perfectly capable of reporting on the facts of the information system, but again here is an area where their judgement is called for. Generally speaking, a poor information system will mean a poorly run business. But poor is a relative term which calls for a comparison with other systems. The accountants should have seen enough other systems to be able to give an opinion. This is what to expect:

• An overview of management information systems

• A descri ption of the main managemen t information reports produced by the company

• A review and assessment of the costing systems

• Management's assessment of whether they have sufficiently accurate and timely information to allow them to monitor and control the business and to react to any opportunities or threats

• Management's views on the future development of systems

• Reporting accountan ts' opinion on the effectiveness of the informa tion systems

• A summary of weaknesses which need to be addressed

Control procedures

Here again the accountants should be able to form a pretty reliable opinion on the quality of the systems for managing and controlling the main financial functions of the company, for example:

• How well credit control and debtor collection operates

• Whether the books and control accounts (debtors, creditors, bank account and cash) are regularly balanced and reconciled

Computer systems

Computer systems may be covered by IT specialists but, if not, reporting accountants will normally:

• Describe the main computer systems

• Review third-party maintenance contracts

• Report on software ownership and maintenance

Fin an cia I due d iii 9 e nee 59

• Report on security

• Assess back-up arrangements

• Assess the adequacy of the current systems for present and future needs


Budgets are an essential planning and control tool in most businesses, so financial due diligence should show how the process works in the target company and, more importantly, how effective it is. Accountants should also be able to come to a view on the current year forecast from an analysis of performance against budget. The Long Form Report will include the following sub-headings:

• Explanation of the budgetary process

• Comments on its effectiveness and on the historical accuracy of budgets

• Performance versus budget since the last accounts date and its impact on the full year forecast


This section is the one which analyses the historical profit and loss account for the business for the last three to six years, together with the most recent management accounts. The approach is to take each category of income and expense and do the following:

1. Break down the figures so tha t their composition can be understood

Z. Analyse the trend in results in relation to each item of income and expenditure to understand:

• any unusual items

• the relationship between the figures

• any underlying patterns

3. Above all, get to understand where the profits come from. Which products are most profitable? Do profits come from trading or, at the other extreme, from the sale of secondhand cars supplied at a discount by the parent?

The closer the investigating accountants can get to being able to use the past to understand the future, the better.

Breaking down the numbers

To see what sort of analysis might be carried out to get behind the numbers, it is probably best to go through an example. Appendix B1 does exactly that. As an aid to understanding the cleaned-up numbers the FDD team will also produce tables which explain the numeric basis to the differences between the years. There is an example of these tables too in Appendix B1.

Analysing the trend in results

Getting behind the numbers, as in the example in Appendix B1, is where financial due diligence provides the real value added. The biggest wins, however, tend to come not from

60 Due D iii 9 e nee

Table 4.3 P&L manipulations and other traps for the unwary

Issue Consequences

Sales have been temporarily inflated or brouq ht forward by 'channel stuffing' Management have resorted to inappropriate revenue recognition in seeking to drive the nu rnbers rather than the business

Generally sales are dependent on sales effort rather than long-term contracts or commitments

• A sign ificant increase in the n umber of credit notes

• Sales drop off rapidly, for example because major customers do not re-order or do not re-order for some time

• There is a need to reverse sales (and profits) booked (especially applicable to work carried out on contracts which span more than one accounting year)

If management have taken their eye off the ball during the sale process, pest-deal sales may fall off because of a. lack of pre- deal sales effort

Increased advertising, for example, has failed to stimulate sales. Potential of the business is less than originally thought

This is more common in some industries than others. Where actua I payments and/or costs are spread over a long period, it is clearly much easier than with a cash busi ness to recognize sales ahead of costs. Sim ilarlyit is quite common, for example,in the construction industry, to find large and complex projects spread over more than one financia I year, and, with many of them, a chance that there will be claims some years after completion. Again, the scope for taking profits early by m is-matching sales and costs is high

In some industries, for example computer software, assets lose their value quickly and need replacing on a regular basis. If assets have been fully written off, recent depreciation will have been low. However, if those assets need replacing in the near future, depreciation will soon be back to much higher levels and profits will suffer accordingly

See under stock, Table 4.4

Attempts to increase sales pre-deal have failed

Sales and cost of sales not matched

Costs are unsustainably low because current depreciation pol icies are inappropriate for the future

Costs deferred by carryinq them forward in closing stock

Costs deferred/reduced by being capitalized

lnterest on borrowings used to finance the construction of fixed assets

R&D capitalized. Not only is the charge to profits reduced but also deferred as the capital ized costs do not need to be amortized until the programme comes into commercial production. Will hit the P&L eventually

The buyer should be concerned about special pre-sale deals and the possibl I ity that suppliers wi II take advantage of a change in ownership to increase prices

• Pre-sales promises made about pay increases or bonuses which the buyer will have to honour

• Cash payments made to avoid national insurance costs have

to cease

• No accruals made for holiday pay/bonuses means a P&L hit

If inter-group transfer prices or related party transactions have been used to keep cost of sales low, post- deal profit will suffer

'Normal' quantity discounts from suppliers over-estimated and over-accrued means a P& L hit

The basic rule which runs through accounting is that losses should be recognized and provided for as soon as they are discovered wh ill'. profits should only be accounted for when they are realized. It is a. rule which is often broken. The uncertainty around losses crystallizing allows them to be fairly easily dismissed, especially when crystallization may be some way off. Post-acquisition will lower profits

Material costs dependent on a few suppliers

Labour costs kept artificially low

Cost of sales kept artificially low

Looming liabilities not provided for

Financial due diligence 61

isolating non-recurring items but from unearthing a profit figure which is higher than it should be where price is based on a multiple of profit. Changing accounting policies is one way to massage profit, but most investigating accountants should be alive to that sort of manipula tion.

More subtle are the 'judgements' which go into constructing a profit and loss account.

Imprudent revenue recognition or the deferral of costs by including them in balance-sheet items like stocks, fixed assets or prepayments are the most frequent means of pushing up reported profitability. Generally speaking these will lead to differences between profit and cash flow. Sadly cash flow is often neglected when analysing financial statements. Any serious discrepancies between profit and cash should arouse suspicion and be explained. Gross margin is another figure to analyse very carefully and an explanation for any changes needs to be pursued until there is a satisfactory explanation.

Table 4.3 shows the areas of risk to the profit and loss account which FDD should watch out for.

Accounting 'judgements' are one thing, but there are other means by which short-term profits can be manipulated, especially if a target has spent the last few years grooming itself for sale. It is possible, for example, to increase short or medium-term profits at the expense of the long-term health of the business. Financial due diligence should seek to identify any such manipulations. The most common is cutting back on investments accounted for as costs such as research, development, marketing and training.

The consequences of short-term profit improvement also need to be understood. Cutting the cost of a branded product by using lower-quality raw materials or switching production to low-cost countries may be perfectly acceptable to customers. On the other hand it is just as possible that once they discover the poorer quality they will lose confidence in the brand and take their allegiance elsewhere. This is where commercial due diligence takes over from financial and provides yet another example of why advisers must be made to work together. The financial team can identify profit improvements which are possibly detrimental to the long-term health of the target business and the commercial team can assess their likely effects.


The approach to the balance sheet section is similar to that for the profit and loss analysis, in that each significant asset and liability is examined to ensure that:

• The basis of values appears to be reasonable

• There has been no distortion in the trend

• Assets and liabilities are properly recorded. It is not unknown for crucial assets not to be owned by the business or for liabilities not to have crystallized yet.

Some of the issues which might be considered under each of the balance sheet headings are covered in the following sections.

Fixed assets

The aim is to assess whether the fixed assets are consistently and reasonably valued and whether they are adequate to support the projected future earnings of the company:

• Are intangible assets reasonably valued?

62 Due D iii 9 e nee

• What is the composition of fixed assets and how have their values been arrived at?

• Are there detailed registers and analyses?

• Have there been any recent independent valuations?

• Are the depreciation policies reasonable and consistently applied?

• Does the company have clear title to its main assets?

• Has the com pany capi talized interest or own labour withi n fixed assets?

• What capital commitments are there?

• What capital expenditure is required?

Even this seemmgty mundane area can have a bearing on negotiations. There have been cases where the indicative offer for a target company included a minimum net assets figure - based on historic numbers - that was quite low. The target was in the middle of a large modernization programme that would need a few more years of sustained capital expenditure. The modernization was key to future profitability, but the low minimum net assets figure in the Heads of Terms gave the vendor every incentive to stop the capital expenditure. The sale and purchase agreement therefore contained a minimum capital expenditure figure in addition to a minimum net assets number.

But the crunch is the second half of the sentence above: are [the fixed assets] adequate to support the projected future earnings of the company? It is not unknown for companies to be groomed for sale. Reducing investment is a good way of flattering both profits (by reducing depreciation) and cash flow. Trawling through the investment numbers over several years may reveal a fall off in investment, but just as effective will be the accountant's interviews with production, operational and technical management.

Stock and work in progress

Stock is the only item which appears both in a company's profit and loss account and in its balance sheet. Given the amount of discretion used in stock valuations, the scope for shortterm profit manipulation and the number of times significant misstatements of accounts turn out to be due to inflated or deflated stock, this is one of the most critical areas for investigation. Relatively small errors in relation to stock and work in progress can significantly distort the overall trend in the results of the company, and the margin for error is vast.

The key is to ensure that the approach to stock and work in progress is acceptable and has been consistent throughout the period under review. This means looking in particular at the basis of valuation, particularly where overheads are included, and at how slow-moving or obsolete stock is identified and provided for. In the UK, the basic rule is that stock should be valued at the lower of cost or net realizable value. Cost, according to the rules set out in SSAP 9, is:

The expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and condition. This expenditure should include, in addition to the cost of purchase, such costs of conversion as are appropriate to that location and condition,

The importance of 'seeing things through' in due diligence is particularly important here. For example, it might be wise to pin down the extent to which movements in gross margin have been influenced by stock values. In particular, the words 'costs of conversion', in the above

Fin an cia I due d iii 9 e nee 63

definition, can hide a multitude of sins. It is probably acceptable if those sins have been committed on a consistent basis but, as any stock carried forward at the year-end could effectively contain an element of deferred expenditure, the danger comes when the many grey areas are exploited to manipulate stock values and hence profit.

Other, more predictable enquiries would include asking about the level of stock losses in recent stock counts, whether the physical condition of stock has been verified, and how any third-party stocks are valued.

Apart from the alarm bells that should ring over recent changes of accounting policy, the areas of risk are summarized in Table 4.4.

Table 4.4 The reasons why stock values could be wrong

Issue Consequences

Conversion costs Direct labour costs, direct production expenses and production fixed overheads are all part of the conversion process, If the actual costs for any of them are going to be charged at a significantly higher rate post-acquisition, for whatever reason, gross profit levels will not be sustainable.

Overhead costs The more overhead which can be included in stock, the higher the profits for the year. The basic rule is that overheads should be classified accord ing to their distinguishing characteristics. The salary of the product.ion manager is therefore a cost of production while that of the marketing manager is not. Overheads should be based on 'normal' activity levels. There are many grey areas which may, or may not, be treated consistently.

Year-end stock Year-end stocks may be built to artificially high levels to boost the level of deferred expenditure carried forward to the next accounting period,

Production inefficiencies Production problems and stock spoilages should be written off to the P&L but in the interests of window-d ressl ng could be carried forward in the stock valuation.

Obsolete/slow-moving stocks

Regular provisions can be too low, thus inflating profits. One-off provisions can be delayed.

Excess provisions made in order to defer tax may be released before sale of the busi ness, artificially boosting profit.

Stock being purchased may not be usable or of the required quality.

Detailed reviews of usage, purchase dates and so on coupled with a walk-through of the plant should help determine its physical state as well as give a rough idea of qua ntity (see next point).

Non-existent stocks

The book position is much hig her than reality due to fraud, deterioration or bad recording. Past profitability is overstated. It is surprising how accurate an idea of stock levels can be gained just by walking through a plant.

Debtors and receivables

Debtors and receivables is another area for careful investigation. Review the credit control procedures, the analyses of aged debtors, the provisions and bad debts written off. Again, it is important to establish whether the approach has been consistent and whether the making and release of provisions or the writing off or writing back of a bad debt could have distorted the trend in the results.

64 Due D iii 9 e nee

The recoverability of the debtors in the most recent balance sheet will be of key importance to the acquirer

• Is the debtor age profile acceptable?

• What is the trend?

• Is there an acceptable system for establishing and enforcing credit terms?

• Are bad debt reserves created on a reasonable basis?

• What is the past experience with bad debts?

• Is the business vulnerable to large debtors defaulting?

Financing and bank arrangements

The investigating accountant will wish to establish whether the cash and bank accounts are properly controlled and whether the company's facilities are adequate and secure. When reviewing the accounting systems the investigator will have established how bank reconciliations are carried out, what the cheque Signatory and authorization limits are and how the treasury function (if relevant) operates. With the bank facilities, the accountant will wish to establish what the terms, conditions and covenants relating to borrowings are and whether the company is likely to have adequate facilities for its foreseeable requirements.

Creditors and other liabilities

These should be analysed in order to identify any liabilities which have not been disclosed or any unusual items or trends in relation to the compan y' s credi tors.

• Does the company receive any special credit terms?

• Is the business under creditor pressure?

• Are there any long-term liabilities such as hire purchase and finance lease obligations?

• Are there any loans from shareholders that could be repayable in the short term?

• The completeness of the liabilities reported in the latest balance sheet? As mentioned above, this will be a key issue. Every business has liabilities which are not recorded in the balance sheet and for every long-term or contingent liability that is recorded, there is a large dose of subjectivity. Are provisions properly made and appropriately calculated? For example, is the warranty provision in the balance sheet in line with what might be expected from warranty terms and product performance?

However long or thorough the investigation, no accountant can be sure of finding every relevant unrecorded liability, but the more experienced will get pretty close because they will know how to look. They will make a point of reading Board Minutes or the minutes of other management meetings for signs of trouble: managers are usually quick to report anything which may come and bite them so as to head off accusations of poor performance. They will rely heavily on their interviews, where they will make a point of speaking to non-financial as well as financial staff and junior managers as well as senior managers, and on their' nose'. For example, a slow-paying, stroppy customer may be more than a simple bad-debt risk. This could be the source of the next legal claim for non-performance.

Share capital and reserves

Details of the share capital together with any options or rights attaching to the shares will have been covered in the first section of the report. Therefore in this section it is necessary to

Fin a n cia I due d iii 9 e nee 65

explain any changes to the share capital and reserves during the period under review and whether there are any unusual reserves or restrictions on distributions to shareholders,

Cash flow statements

Cash flow is as widely used in valuation as profit. The relationship between profit and cash generation is a vital piece of knowledge which FDD must report on as thoroughly as possible. There may be perfectly good reasons for differences between profit and cash. A heavy investment programme may be one, as may sales growth. On the other hand it could be down to poor cash management which, for example, could manifest itself as frequent breaches of overdraft limits.


Tax is a subject all of its own (see Chapter 10). Tax due diligence is best carried out by a tax expert. He or she win carry out a detailed review of the tax affairs of the company and assess whether the tax provisions are adequate and whether there is a risk of additional tax liabilities emerging.

The financial due diligence team and the tax due diligence team will have to work closely, and indeed the investigating accountants may be best employed as information-gatherers for the tax specialists. This leaves them with the general tax role of commenting on how up-todate the target's affairs are in the various areas of taxation and whether there are disputes, taxes overdue or investigations pending. They should also give an assessment on how aggressive the target company has been with its tax planning.


Not every piece of FDD includes a section on forecasts. It is not necessary where the intention is a fundamental change in the way the target does business. For the rest in many ways this section is the nub of the whole exercise. What does the future hold? Sadly, it is a topic which makes reporting accountants very nervous. The further forward the forecasts go, the more nervous they get. Depending on the industry, they will take the view that a twelve-month period is reasonably forecastable but are loath to go much further.

Left to thelr own devices, reporting accountants will confine their findings to a pretty clinical review of the target's forecasts. Typically they will set out to answer the following questions:

• Have the forecasts been correctly compiled on the basis of the stated assumptions?

• Are those assumptions reasonable?

• Are they clerically accurate?

• Are the accounting policies used consistent with the usual polictes?

• How accurate has forecasting been in the past?

• Are the forecasts consistent with the trends in the management accounts?

• What are the vulnerabilities?

• What are the key sensitivities in the forecast?

The typical forecast for any business is a 'hockey stick' a cou pie of years out. Where a business is being sold, an even brighter picture of the future is painted. Accountants should always seek to separate the concrete reasons why the future is going to be so much better (for

66 Due D iii 9 e n c e

example, new products and new customers in the pipeline, new cheaper supply sources) from management's wish list, but they will rarely go further than giving comfort on the level of care that has gone in to preparing the forecasts.

As worthy as the above work may be, it is not exactly rolIing back the frontiers of knowledge. If ever there was an area ripe for two of the due diligence advisers to be made to work closely together it is in this one. The financial due diligence team will have built up a detailed picture of the workings of the business while the commercial due diligence team will know all about market prospects and the target's competitive position. Do not let them work in splendid isolation. Put the two together to review the projections and to come up with longer-term forecasts!

The value of this approach even for relatively short-term forecasting was demonstrated during due diligence of a company that makes 'big-ticket' products used in large construction projects. The target's forecasts were basically the sum of the value of all contracts bid multiplied by their assessment of their chances of winning the work. So, for example, a contract worth £2 million that the target estimated it had a 50 per cent chance of winning would go into the forecasts at £1 million. The due diligence team was able to speak to a large sample of people responsible for awarding those contracts and get a pretty good handle on forecasts for the next couple of years. For longer-term forecasts, the traditional commercial due diligence topics take on an increasingly important role. Market growth, the target's ability to win share and pressure on prices will have a much bigger influence on the bottom line than the minutiae of accounting such as trade creditor reversals or provisions for slow moving stock.

No forecast is ever 'right'. Due diligence is more about understanding the range of possible outcomes and the risks inherent in the business. Again, the financial and commercial teams should be working together on sensi tivi ties. If you leave sensitivities to the typical due diligence accountant what you will get is the near mechanical application of what-its: 'What if prices decline by 5 per cent?', 'What if the market turns down by 10 per cent next year?'. On the other hand, if you leave the average commercial due diligence team to comment on forecasts you will get no numbers but trend lines and ticks in boxes instead. What is called for is a bit of synergy from the advisers.

In short, two plus two does equal five if the commercial and financial due diligence teams can be made to work together on forecasts and sensitivities. The seasoned opinion of the commercial due diligence expert, armed with first-hand knowledge of market drivers and competitive position, and the analytical prowess of the accountants, armed with a financial model of the business, ought to be a devastating combination. As well as getting the commercial and financial teams to work together on forecasts, it is also a good idea to involve those managers who are going to be running the business.

Critical for the buyer is to know the odds of forecasts being achieved. Press for opinions.

And do not wait for a bland, descriptive, assessment of forecasts or 'negative assurances'.' Get across during the selection and/or briefing of investigating accountants that you want opinions, and opinions is what you will get. Finally, if the plan is to reorganize the target postacquisition, or to merge it with other operations, the buyer might be just as interested in the accountants' opinion on the post-acquisition/post-reorganization forecasts as on the target's.


This section is really a collection of items that have come to light during the financial investigation. For example, here might be noted whether there is any litigation going on or

Fin an cia I due d iii 9 e nee 67

about to start, whether there are any contingent liabilities, any capital expenditure committed and a summary of employee pension arrangements.


You are not going to feel comfortable if you do not commission financial due diligence. The challenge is to get good value. The term 'reporting accountants' is a good one because left to their own devices they win only report. This is not all bad. You need to understand the routine accounting issues, you need to understand underlying profit, you need an assurance that the balance sheet is clean and that the profit and loss account has not been overly manipulated. If you employ accountants to cover pensions and tax, you will certainly want to make sure that there is nothing which is going to come back and bite you.

But you should want more. You want to understand the quality of the target and the extent to which it meets your strategic objectives. This means that you want firm opinions from the accountants on non-financial as well as financial issues. More than any other adviser, these are the people who will spend most time closely observing the target and its management. Make sure they understand the importance of their 'intelligence' role and make sure their team is capable of performing tha t role.

CHAPTER 5 Legal due diligence

This is a surprisingly short chapter given that the words 'lawyers' and 'due diligence' are almost synonymous. The reason is simple. Many of the specialist legal issues are covered in subsequent chapters. Legal due diligence is central to the entire due diligence programme because it forms the basis for the sale and purchase agreement. Given this, it is doubly important that legal advisers work closely with the other due diligence professionals and focus on the commercial implications of their findings. Lawyers are trained to spot problems but what is needed is for those problems to be put in their proper commercial perspective.


Legal due diligence is undertaken to achieve three objectives. These are to:

• uncover potential Itabilities

• find any legal or contractual obstacles

• form the basis of the final agreement.

Each of these is covered in turn below.


In an asset sale, purchasers do not normally take over liabilities. They are only responsible for liabilities (although employment liabilities and obligations are an exception here) if they specifically contract with the seller to take them over. A company, on the other hand, is a separate legal entity and as such normally comes with liabilities as well as assets. In other words, if the buyer buys the company, it will continue to be responsible for the liabilities of the company. Liabilities come in three guises:

• actual

• future

• contingent.

Some liabilities will be quantified, recorded and provided for. Others will not. As well as verifying the size of known liabilities, the purchaser of a company should make as certain as is possible that there are no sizeable unforeseen liabilities lurking in the background. At the very least these will mean the buyer has paid more than it should have. At worst, as for example in the case of Atlantic Computers (see Chapter 3), they can bankrupt the buyer.

Liabilities that are not recorded in company accounts can come from a whole host of sources, many of which are dealt with in subsequent chapters, and, as far as the lawyers are

Leg a I due d iii 9 e n c e 69

concerned, sometimes from other specialists. Pensions (Chapter 9) is perhaps the biggest worry in this area with tax (Chapter 10) not far behind. Depending on the post-acquisition plans, human resources (Chapter 7) can be a legal minefield. Any would-be US acquirers in Europe would do well to pay particular attention to this subject in due diligence. Unlike back home, European labour laws, especially outside Great Britain, can be very tough. If part of your post-acquisition plan is to close that expensive Paris head office, take local legal advice and look very carefully at how much it is going to cost (and how long it is going to take).

The overlap with other discipllnes does not stop there. Legal investigators need to understand the financial and accounting position of the target company and should also be concerned with the contractual issues in the financial area such as loan agreements, charges, guarantees and indemnities given by the target company and any other banking arrange· ments that may be in place.

Environmental due diligence is another area where lawyers tend to get involved. Most of the big law firms will have environmental practices. As discussed in more detail in Chapter 11, the purchaser will need to find out whether there will be a responsibility for cleaning up polluted land, whether environmental permits are needed and are transferable, whether the target (and its predecessors) have complied with environmental laws and regulations and whether the target has adequate systems and procedures for complying with environmental regulations.

Intellectual property is a highly specialist legal area, although there is more to it than the purely legal, as we shall see in Chapter 14. The intellectual property rights of the target company need to be identified, their ownership verified, their validity established and, perhaps most important of all, their sufficiency confirmed.

Contracts could also be a source of unforeseen liabilities. Lawyers will review major contracts and agreements, first to make sure they contain no nasties and second to confirm they can be transferred to the purchaser. Change of control clauses are ]e.kyll and Hyde characters. On the one hand they are useful for certainty and stability, on the other they present the perfect opportunity to renegotiate the original contract.

Another source of potential liabilities is litigation. One of the main tasks of legal due diligence is reporting on any litigation or disputes affecting the target company. What the buyer does not want here is a list. Anyone could provide a list of pending or threatened litigation and there is no need to hire expensive lawyers for that. Where the lawyers come in is in assessing the likely damage litigation will cause. One element of this is gauging the chances of success or failure and likely cost. The other is bringing streetwise judgement and experience to a list of outstanding litigation in order to spot the danger signs. In the scheme of things, a few claims for industrial deafness against the target are neither here nor there. The same number of claims for lung damage allegedly caused by exposure to asbestos should set all sorts of alarm bells ringing.

The lawyers will also look closely at legal structure. Legal structure is important because there can be all sorts of problems which arise when a company leaves a group. There are obvious ones like capital gains tax liabilities being triggered because of inter-group transfers of assets Of change of control clauses in licences and distribution agreements. There are less obvious ones like the target company no longer being able to benefit from group discounts. And there are totally off the wall ones (and this is a true story) like the seller having already sold the target's intermediate holding company to somebody else without realizing it.

Given the degree of overlap with other spectaltsms, it hardly needs saying that due diligence lawyers must liaise with other due diligence professionals.

70 Due D iii 9 e n c e



Buying a company means buying its shares. Shares in the target wiJl have owners. The lawyers need to check that those from whom the shares are to be bought actually legally own them and that the new owner is not going to be responsible for any liabilities attaching to the shares which were entered into by the previous owners. This means:

• Inspecting documents relating to the allotment and issue and transfers of shares, the a pproval of transfers at board meetings and registration of the various transfer documents .

• Checking that former shareholders have returned their certificates and that current shareholders, or at least those who are selling their shares, have certificates.

• Verifying that the shares to be sold are not subject to any charges or other encumbrances.

In a similar vein, the legal investigators need to verify good title to, that is that the target actually owns, any freehold or leasehold property and any other major assets. As with their investigation of shares, they should also investigate whether there are charges or other encumbrances over property or assets. The effect of a charge on the value of land, property or assets is fairly obvious. Encumbrances can affect the value of the land in a number of more subtle ways such as its marketability or even the right to continue using it for purposes of the business.

The purchaser will also be interested in finding out about any breaches of covenant and, for leasehold property, any breaches of the lease(s).

The right to domain names also needs checking. Just because a company owns a trademark does not give it the right to own the domain name as well. People have been registering Internet domain names which include the names of well-known companies. This probably counts as passing off or infringement of trading names but, nevertheless, a buyer should check that the target has taken steps to protect itself from this sort of activity. Registering everything could be expensive and unnecessary. It is therefore important to decide which names could be useful in the future and which are irrelevant.

Consents and releases

These days the sale of a company or business is likely to require a number of consents or releases. For example, a target company's shares may need release from a parent company debenture, one group of shareholders might have pre-emption rights, the deal might need merger control clearance (Chapter 12) or there might be a need to consult with the target's works councils or joint venture partners, The legal due diligence advisers should help identify what needs to be done so that consents and releases do not delay the transaction.

Regulatory issues

The purchaser needs to see any licences, permissions and registrations which are necessary for lawful conduct of the target company's business. For example in the UK any company carrying on a financial services business needs authorization from the Securities and Futures Authority (SFA). Regulatory bodies such as this usually keep lists of companies registered to act under its auspices.

If the target company does require a special licence to carryon business then it should be

Legal due diligence 71

verified that this is in force and not about to be taken away. At the same time it should be checked whether the acquisition would affect the licence in any way. The buyer's legal advisers should look at three different, but related, licensing issues:

• Which licences does the target not have which it should have?

• Whether the licences are transferable. If you are buying the company which holds the licences this is not an issue. Where it becomes an issue is where you are buying assets or where the licences are held by another entity, by the parent company for example.

• If licences are not transferable, will new licences be forthcoming?

Due diligence is always carried out at a breakneck pace whereas dealing with licensing authorities can be a tortuously slow grind. If the lawyers cannot satisfy you on the above in time, it could be a case of making completion conditional upon a licence being granted. The importance of authorizations differs by industry. In the food industry in the UK, for example, it is difficult to do very much without authorizations.

Alternatively the target may be part of an elite 'club' or trade association which confers prestige and respectability. Its standing in important organizations needs to be checked. Industry bodies very often police industry codes of practice. Has the target been complying with these?

Special accreditations may be central to a target company's profitability. For example it may be accredited as being able to test safety critical equipment to relevant health and safety standards. This should be checked as standards have a habit of changing.


The sale and purchase agreement records the legal understandings of the buyer and seller about the transaction. The document has three basic goals. These are to:

• bind both parties to completing the transaction

• ensure the seller does not change the company in any significant way before the deal completes

• govern what happens if problems appear that should have been disclosed

Most of the negotiating effort that goes into the agreement is about who picks up the bill for company defects that appear after the deal is done. This means that, in one form or another, information from the due diligence programme will be included in the disclosure letter and a good deal of it will end up being included in the agreement. Both sides will be happy with this. For the seller, the contents of the disclosure letter will qualify the warranties. The seller will not be liable for the matters disclosed. The purchaser gets peace of mind because the contents of the disclosure letter, including a lot of the due diligence information, will be warranted as accurate. This in turn explains why lawyers play such a pivotal role and why it is often the in-house lawyer who usually ends up coordinating due diligence.

Choice of advisers - local advice

Chapter 3 discussed the choice of advisers. There is one further consideration when it comes

72 Due Diligence

to choosing legal advisers and that is that different due diligence topics could be governed by different laws. For example, the law under which the target company is incorporated will govern the constitution of the target and the rules about the ownership and transfer of its shares, whereas its interests in land or property will be governed by the laws of the country in which that land or property is situated and employment issues are likely to be governed by the laws of the countries in which the employees are based. Although the most obvious differences are between common law systems (such as in England and all of the USA except Louisiana) and civil law systems (for example in continental European countries), there are significant differences even between systems that have the same origin.

For all of these reasons, it is very important to take local advice where foreign law issues are involved. Sometimes local can mean very local indeed:

If we made a mistake in our choice of lawyer, it was only that we chose a New York attorney to fight a case in Chicago, thereby opening ourselves up to suffer by the enmity between the two cities. I

It is also worth remembering that in some countries the law is not the law, but a goaL Be realistic about what local legal advice can sometimes achieve.

Briefing lawyers

A theme which runs throughout this book is the very strong relationship between the quality of the due diligence and the buyer's management of the process. Briefing advisers is an important part of due diligence management, and a good briefing is doubly important in the case of legal advisers. They are central to the deal so they must know everything there is to know about it. Many lawyers will privately tell you that they find due diligence an impossible exercise and the reason they find it so difficult can be traced to the quality of the briefing they are given. Typically they will suddenly be confronted by a very large volume of information in the form of copies of documents. They must read all of them and assess their consequences. How, without a proper understanding of the context of the deal or the buyer'S concerns, can this be done? How can any lawyer know whether a change of control clause in a contract is significant without a proper briefing?

The process

Data rooms apart, the normal starting point for the purchaser is to kick off a number of searches and at the same time to send the seller's lawyers a request for information (see Appendix A2). This is a very detailed questionnaire, normally drawn up by modifying a standard, comprehensive form by deleting inappropriate questions and adding questions which are specific to the nature of the transaction, the nature of the business or need to be answered following initial investigations. For example, commercial due diligence or industry knowledge may have revealed that although the target's UK market position is deteriorating rapidly (and is perhaps being kept artificially high) there is tremendous scope for expansion in Germany. However, the official German distributor is hopeless and much of the demand in Germany is being satisfied by unofficial parallel imports. In this case, legal due diligence

Legal due diligence 73

should be very concerned about contractual terms between the target company and its German distributor because clearly this is going to be a major issue once the deal is done.

Getting the questions right is a must. Be focused and show that you are focused and you will get the best results. There is nothing worse for a seller than receiving a long meandering list of questions which are irrelevant to the target. Would you be convinced of the need to put yourself out to provide accurate and pertinent information quickly if you think that the buyer's advisers, and therefore by implication the buyer, are robotically going through the motions, through a checklist, rather than focusing on the real issues and appearing to know what they are doing? Nevertheless, as ever, there is a balance to be struck and questions do have to be framed in sufficiently broad terms to elicit all the information required.

Carrying out the investigation

In many cases there will be other advisers specializing in one or more of the areas legal due diligence needs to cover. If specialists do need to be commissioned, remember tha t extra time is going will be required for them to finish their work and for their findings to be incorporated into the process. Some may also need much more access than the seller had initially contemplated.

Similarly, the odds are that more time is going to be needed if there are subsidiaries or significant assets in overseas jurisdictions. Some local due diligence will have to be carried out by local lawyers. Local law may also have timing implications for the transaction. Language barriers and time differences will do little to speed up the process and cultural differences, including fundamental misunderstandings of what due diligence is about, can stop a transaction dead. By no means all the world is steeped in the sacred Anglo-Saxon tradition of caveat emptor. In many parts of the world a request to carry out due diligence is very likely to be responded to with 'if you don't trust me, push off'.

Getting the information

Most of the information for legal due diligence will come from the seller. The seller's lawyers will normally coordinate the preparation of responses to the questionnaire and the collection and distribution of any documentation requested.

The buyer needs to be sure that someone on his or her side keeps a careful record of what is received when and to whom it has been circulated. There are a number of software packages around to assist with this tedious but necessary task.

Once the buyer's legal advisers start receiving replies to their request for information, they will start to review them. It is normal for this information and documentation to be reviewed in a fairly mechanical way. This has a number of advantages, not least that it is a cost-effective way of getting through large amounts of detailed information in a relatively short time. It should also leave partners and more experienced practitioners more time for supervision and to investigate the most important items. This is also good. It cannot be said often enough that there is no substitute for large amount of streetwise detective work by experienced professionals.

74 Due D iii 9 e n c e

Other information sources


The disclosure letter is itself a source of due diligence information. Sellers often deliver the disclosure letter at the very last minute possible so that you do not get the chance to go through it properly. The motive? Simple: the less time you have to comb through reams of information the lower the odds of you noticing the odd controversial (and no doubt potentially expensive) item slipped in.

The purchaser should always insist that the seller delivers an early draft so that the due diligence process can get underway in a meaningful fashion. You should not however expect it to be the final version of the disclosure letter which is submi tted first. Disclosure letters will go through a succession of drafts. Each draft will disclose more information especially since the purchaser and its advisers should be asking questions about the information disclosed and seeking further and better particulars.


More often than not other advisers will complete their due diligence before the legal due diligence is finished. It has already been stressed that legal due diligence cuts across many other areas. Other advisers should be encouraged to highlight any concerns which may need special attention for the legal advisers. Similarly, the legal advisers should make a point of speaking to the other advisers to make sure nothing falls between the cracks Atlantic Computers style (see Chapter 3). Better still, the buyer should do it for them and make sure all paints of concern are communicated to the legal advisers. This helps with the documentation as well as the legal due diligence.


The process of information requesting and reviewing goes on until the purchaser is satisfied, everyone gets fed up, or one of the principals presses the button for completion. While the legal advisers are waiting for a reply to the request for information or the first draft of the disclosure letter, they will probably build up a profile of the target from published information. There is an enormous amount of company information in the public domain.


The internet and subscription databases are probably the first stop, although as part of the initial briefing the purchaser should have given the legal team enough general company and industry background to short-circuit this stage. The investigating lawyers need to start with a good idea of the nature of the target company, its business and its affairs over the past three to five years to use as a guide to where to concentrate their efforts.

Credit reference agencies

Credit reference agencies will provide a credit risk assessment of the target company and give hints as to how it is regarded by the wider business community.

Legal due diligence 75


As well as using public information as a means of building up a general profile there is much which can be used for more specific enquiries.


In the UK, if property is registered, a search of the Land Registry wiIl reveal the owner, the benefits attaching to the land and any encumbrances such as mortgages and restrictive covenants. It will also have a plan showing the boundaries of the property.

If the property is unregistered, its ownership can only be confirmed by inspecting the title deeds. However, a search at the Land Registry will reveal that it is unregistered and a search at the Land Charges Department in Plymouth will show details of mortgages, restrictive covenants, adverse easements, matrimonial land charges and so on. (The search is made against the name of the owner of the property rather than the property itself.) In the case of Limited Liability companies, Companies House information will also give details of charges against property, registered or unregistered.

In the UK, Local Authority searches will show planned changes to the area, for example whether a motorway is planned to go through the property. The local land charges registry will say whether a building is listed or in a conservation area or whether it has to comply with local planning enforcement notices.

Especially now that new developments are being encouraged on brownfield sites it is not unusual for modern premises to be built on reclaimed land. A buyer would probably want to know if a factory has been built over, for example, old mine workings. It is possible to search specialist registries to find, for example, where the coalmines once were. Chapter lIon environmental due diligence makes the point that it is not just the obvious industrial sites that could cause concern. A brand new building on a brand new office park could be a considerable burden if built on an old rubbish tip which is still giving off large quantities of methane.

Companies registration office

In some countries there is a system for filing company documents. In a place such as Companies House in the UK, there is a central registry which contains the target company's latest filed accounts, and details of its constitution, shareholders, officers, changes in the directors and secretary and notices of appointments of receivers, liquidators and so on. There is usually a short delay in documents actually getting in the files so in the UK, for example, changes made in the last 21 days will not yet be recorded.

The Register of Disqualified Directors at Companies House will show if a person has been disqualified as a director. The Land Charges Registry will reveal whether any individual sellers or directors have any bankruptcy proceedings outstanding or pending.

As well as conducting a search on the target and its subsidiaries, the legal advisers will probably search the seller too, just to check it has the powers to sell the target company.


Where the buyer wishes to verify the status of any pending litigation disclosed by the target or where searches need to be made to ensure that no steps have been taken to put it into receivership or administration or to wind it up altogether, searches can be made at Court.

76 Due D iii 9 e nee

Restri ctive tra de practices reg i ster

In the UK, details of any registered agreement under the Fair Trading Act have to be registered. There may be restrictions registered which benefit, or which may bind, the target.

The report

Lawyers more than anyone else know they are not going to be sued for reporting too much so, without a proper briefing from the buyer, the legal report will tend to be a long, incoherent, rambling affair, stuffed full of every detail. This will be supported by a mountain of copies of the documentation supplied by the seller.

The challenge is to manage the lawyers properly. Insist on:

• Drafts of the report

• A commentary on issues as they turn up

• An executive summary at the start of the report which identifies the major issues and gives an opinion on how they should be addressed in the sale and purchase agreement

• A presentation of findings, again covering the highlights and how to deal with them

And when you say 'major' or 'highlights', make sure the meaning of the term is properly understood. A leading in-house lawyer recounts the story of the time he asked his legal advisers to set out the highlights of a long and complex global merger for the board. He got 63 pages.


Legal due diligence covers a multitude of specialities as well as the more obvious legal areas such as title, consents and releases, and regulatory issues. The same firm of lawyers could well cover some, or all, of these. If other specialists are involved, the lawyers must liaise very closely with them because what they find could be an important input to the final agreement. For the same reason even where the lawyers cover all the 'legal' disciplines, they still need to work closely with other advisers and with overseas lawyers where local advice is needed on cross-border issues. When it comes to reporting, you should make sure they liaise with you throughout the transaction and make sure they give you an executive summary which highlights the key commercial issues. Insist on a presentation of their findings. Above all, ask for, and get, opinions. You are paying for opinions, not paper.

CHAPTER 6 Commercial due diligence

A company is acquired not for its past performance but for its ability to generate profits in the future. Commercial due diligence (CDD) is all about estimating future performance. In contrast to most other forms of due diligence, it looks outside the target for its information. CDD gets its information hom published sources but, more importantly, by talking to knowledgeable people in the same market as the target. As well as being an important activity in its own right, this can make commercial due diligence a complementary activity to other forms of due diligence, especially financial, technical, cultural and intellectual property, and sometimes even antitrust, due diligence.

In its traditional form, commercial due diligence is the investigation of a company's market(s), competitive position(s) and, putting the two together, its future prospects. It fits into the deal evaluation process as shown in Figure 6.1.

Commercial due diligence

- - - - - - - - - - - - - - - - --



, Historic performance
, Underlying •
Market ~ financial • Potential improvements
, performance
, I
, +
, 4
, f----+ Financial _____.. Stand-alone
, Prospects
, forecasts valuation
, r+
, .,.
, I
Competitive --+ Liabilities/additional
position , costs
, Figure 6.1 The deal evaluation process


Traditionally commercial due diligence has had three aims:

78 Due D iii 9 e n c e

• Reducing risk. Purchase price is normally a ratio of current profit but if future profit is under threat, say because customers are about to desert the target, the buyer needs to know this and negotiate the price down accordingIy.

• To help with valuation. Projecting a business ten years out is not easy, yet this is exactly what a discounted cash flow demands. It certainly cannot be done using just historic financials .

• To help plan integration. Bad integration is a major reason why acquisitions fail.

Commercial due diligence examines the target's markets and commercial performance. In so doing, it identifies strengths and weaknesses which should be addressed as part of the integration process.

These are perfectly valid roles for COO, and probably exactly what is needed on some smaller deals. Ideally, however, COD should go much further.

If approached from a strategic angle, commercial due diligence will go beyond simply evaluating the risk that the future performance of the company will fall below the forecasts on which the price of the business is calculated. Giving comfort on the immediate top line, and maybe gross margin, is an important output of COD and it would be a waste of a good investigation if the output from COD was not fed into financial forecasts. Ideally, though, the aim of commercial due diligence should be to give comfort that the deal will actually work. This is true even where the buyer is a financial buyer and the acquisition is going to stand alone. There is going to be no integration, and no synergies, but the financial buyer will probably be looking for an exit in three years or so. It is here that strategic COD comes into its own. Buying now with a view to exiting requires a strategic understanding of the target and its market in order to understand the prospects of selling the business.

COD, then, should be seen as much more than a market review or customer referencing.

It should instead be seen as a mini strategy review - 'mini' only because of the tight trmescales in which the work is done.

Many acquisitions are carried out for the wrong reason, which perhaps goes a long way to explaining why the failure rate is so high. To succeed, they should be used as a strategic tool. The point of strategy is to improve returns - or at least to stop them deteriorating any more than they otherwise would. This means improving profit. Profit is sales less costs. Sales are the product of price and volume. Costs come in two varieties - fixed and variable. This is shown in Figure 6.2. It is worth bearing this simple picture in mind as we discuss the strategic benefits of commercial due diligence.

There is really only one strategic benefit on the cost-saving side available from acquisition: economies of scale. These can derive from nearly every function of the business. In mature industries they will come from cutting underused capacity, say by folding two factories into one and reducing duplicated overheads so that base costs are reduced. Or scale economies could be about building R&D and sales and distribution capability as, for example, in Glaxo's acquisition of Wellcome in 1995. Drug prices were being forced down as central buying authorities took over from doctors as the main buying influence. Fragmented and relatively price insensitive buyers/specifiers gave way to much more powerful and priceconscious buyers. At the same time, a record number of patents were expiring. Suddenly drug companies needed to be very big to be able to afford the R&D which would lead to th e patent protection which in turn would mitigate the price pressures. Getting patented solutions specified by doctors also called for a big salesforce to get the coverage. The more drugs it had to sell, the more cost effective would be the salestorce. Another source of economies of scale could come about by bigger purchases and therefore variable cost savings.

Com mer cia I due d iii 9 e n c e 79








Figure 6.2 The components of profit

The point of all the above examples is that cost per unit is now lower, and competitive position improved ~ because any competitors without the same scale now either have to reach the same scale or stay at a small scale and risk cost disadvantage. But the critical thing is the mathematical implication of the phrase cost per unit. The assumption is that the number of pre-merger units at least stays constant, otherwise cost per unit is likely to go up compared with the pre-deal position. In other words, a company could achieve all sorts of cost savings through acquisition but still be worse off if the sales of the combined entity fall. Sadly, the evidence (see for example McKinsey QlIarterly 2001 Number 4) seems to point to sales being lost in acquisitions! According to the Financial Times,

Most mergers that fail do so because revenue growth stalls during integration and fails to recover. 1

This is not good news because sales tend to hit the bottom line much harder than costs. A simple illustration will serve to show this. Company A and company B both have a 25 per cent gross margin and make 10 per cent profit on sales on £100m. Both are growing at 2 per cent in real terms. Company A buys company B for a 30 per cent premium over its cash flows for the next 10 years discounted at A's cost of capital. The graph in Figure 6.3 shows the trade-off between sales growth and costs for the shareholders in company A to be no worse off after the acquisition.

If growth continues at 2 per cent, costs must be cut by just over 1 per cent for value not to be destroyed. In other words, by cutting costs by just over 1 per cent, in year 10 company A will be earning the same as both companies would have earned had the acquisition not been made plus it will make an adequate return on the premium it paid to buy company B. Combined costs in the first year of acquisition are £183 million and must be cut by what looks like a fairly modest £2 minion.

Look what happens, though, when growth is zero. Now fixed and variable costs have to be cut by £13 million or six and a half times the 'with-growth' amount ~ and this is after variable costs have fallen by £3 million because of the lack of sales growth.

80 Due D iii 9 e n c e


10 ~

81 ~


0') 6 c

4 2 o







Sales growth (%)



Figure 6.3 The trade-off between cost savings and sales growth

It gets worse. Up to 40 per cent of all mergers fail to capture identified cost synergies- and on top of this, cost savings have a nasty habit of being short-term, one-off gains or of leading to a downward spiral of low motivation and falling performance. As the old saying goes, 'downsized, right-sized, capsized'.

And all of this is just to stand still. From the above it is clear that if profits are to grow, then sales are going to have to grow more than they otherwise would have. To do this the acquisition must bring a strategic advantage. In other words, the acquisition must be aimed at taking the acquirer to a new level relative to the competition. Even if the only strategic advantage an acquisition brings is economies of scale, sales are going to have to increase more than they otherwise would have done for that advantage to be realized.

In many cases, the reality is that,

problems often result from transactional myopia and strategies based on optimism, rather than reality. The focus becomes the nuts and bolts of the transaction. Forgotten are the sources of its profitability and cash flow, an understanding of its market and the need to maintain a close relationship with the customer."


The conclusions from all this are straightforward:

• First of all, commercial due diligence must focus on the ability, post-acquisition, to achieve sales growth, that is to win price increases or sales increases, or both.

• Second, it should not just concentrate on the pre-acquisition position of the target but should assess the likely strategic position of the combined entity - unless the target is going to run as a stand-alone business.

Commercial due diligence 81

Table 6.1 The headings for a commercial due diligence exercise


Competitive position of the combined entity

Degree of industry rivalry;

Relative share

Rationality of competitors

Performance relative to the competition against customers' purchasing criteria

Prod uct strengths relative to competitors':


• Number of firms

• Relative shares

• Degree of differentiation

• Stage of in dust I)' life cycle

• Demand/supply balance

• Fixed cost intensity

• Heig ht of exit barriers

• Performance

• Differentiation

• Innovation

Relative distribution strengths:

Buyer power:

• Relative size of customers

• Degree of custom er concentration

• Profitability of customers

• Cost of product relative to buyer's total costs

• Importance to performance of customer's product

• Ease of backward integration

• Ease of switching/cost of switching/ availability of substitutes

• On-time deliveries

• D.istributor network

• Salesforce

• Back office

• Location/access to markets

• Strength of customer relationships

Brand strengths

Costs relative to those of the competition:

• Cost base

• Proprietary technology or know-how

Threat of new entrants:

• Cost of know-how

• New technology

• Cost of plant and equipment

• Importance of experience

• Economies of scale

Degree of commoditization


Existing market share Market growth

Stage of product life cycle Threat of new products Shifts in technology Cyclicalitylstage of cycle Change of regulations

Segments served Segments not served New te rri tori es

New applications New products

Once this is understood, the subject headings for CDD fall straight out of a strategy textbook, as is shown in Table 6.1.

To make the point once again, doing commercial due diligence properly means looking not just at the market. It must be concerned above all with the post-acquisition competitive position within it. Just because a market is big and growing does not necessarily mean the acquisition is well placed to benefit. A deal to buy a niche manufacturer of construction equipment in a market growing at 20 per cent a year was halted when due diligence pointed

82 Due D iii 9 e n c e

out that this particular manufacturer's niche was never going to grow at the same rate as the overall market.


The above is COO in its full form. COD is not always carried out in its full form, especially on smaller deals in familiar markets. What is done is very much up to whoever commissions the work. Whether or not to conduct COD, how much to do and where to concentrate resources is a business judgement based on the balance of risk and knowledge. Factors to be considered would include:

• The buyer's existing knowledge: companies which are already active in a market should know their market welL All too often, though, when companies think they know about markets they do not, or rather their knowledge is of the wrong kind to assess future prospects. Also, deals where the overlap between two companies is total are rare. There may be competition between acquirer and target in certain areas, but there are also likely to be activities, market segments or geographical markets about which the buyer knows next to nothing.

• The perceived level of risk: if you are buying a small company, in the same market as yours, where the consequences of the deal going wrong are minor and there are no unanswered integration questions, the level of perceived risk is low.

• The size of the deal: deal size and risk are often rela ted in the minds of buyers,

• The need for 'political' justification or to convince potential investors, lenders or a sceptical board.

• The audience: a full PLC board is going to want much more than sayan owner-manager who has been in the business a long time. Banks wt 11 need even more.

• What claims the seller has made that sound peculiar or are critical to valuation and/or the target's future.

• The information and analysis needed to get the deal done, for example to justify the price being paid. Here again, though, it is important to look at the target's competitive position as well as examining the market. Market due diligence alone is not enough to answer the questions that need to be asked just to complete the deal. Questions like 'Is this company any good?', 'Am I paying too much for it?' need to take into account competitive position as well as market factors. The competitive position of the target is fundamental to its future performance and therefore its value. A target market may well be attractive, but there is no guarantee that an acquisition candidate will perform in line with the market and although competitive positions can be changed with investment and new management, the competitive position now is going to give a good indication of where the weaknesses are, what needs to be done and, therefore, the time and resources needed to improve the target's position.

• Any other particular areas of concern.

• Whether a proper strategic review (of the buyer) was felt necessary as an underpinning of any proposed acquisition.

• The reasons for the deal, If we go back to Table 2.3 in Chapter 2, the focus of CD 0 might be different according to the reasons for the deal, as shown in Table 6.2.

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Table 6.2 The commercial due dl1igence focus will vary with the type of deal


Strategic objectives

COO iocus

The overcapacity M&A Eliminate overcapacity, gain market share, Ability to retain market share, market

achieve scale economies

growth, competitor reaction, relative strategic advantage post-deal

The Geographic Roll-up M&A

A successful company expands qeoqraphically: operating units remain local

Strength of local operations and local management, target's ability to continue meeting customers' key purchase criteria, market growth

Product or market extension M&A

Acquisition to extend a company's product line or its international coverage

Strength of product relative to competition, strength of customer relationships, target's ability to continue meeting customers' key purchase criteria, market growth, competitor reaction, cross- selling opportunities, distribution/marketing synergies

The M&A as R&D

Acquisitions used instead of in-house R&D to build a market position quickly

Target's relative market position, industry and technolog leal trends, customer acceptance 01 the product! technology, target management ability, originality of the technology being acquired, assessment of competing technologies

The Industry Convergence M&A

A company bets that a new industry is emerging and tries to establish a position by culling resources from existing industries whose boundaries are eroding

I ndustry and technological trends, target's product/technical capability

All of this means that commercial due diligence can be highly tailored and, as well as the general headings of market and competitive posttton, could include some very specific topics such as:

• Management

• Cross-selling opportunities

• Customers' immediate sourcing intentions

• Ability to penetrate new geographical or product markets

• Intelligence on the market or a target before an approach

• Future legislation/regulations

• Trading conditions in important parts of the market

• Imminent technological changes which might threaten the demand for one of the company's major products or services

• Whether a rna j or new com petitor is considering en tering the market

84 Due D iii 9 e nee

• Degree to which the target is vulnerable to loss of large customers

• Degree to which a new product or service can be roIled out nationally

• Whether or not the target has been damaged by the sale process

• Analysis and forecast of the prospects for individual product lines

To sum up, the problem with many COO investigations is that they easily become pieces of marketing due diligence looking, for example, at the ability of the target's salesforce and other detailed day-to-day sales and marketing issues. While this is important, much more important are the strategic issues - the strategic issues behind the deal, not just the strategic position of the target. Marketing issues can be fixed; strategic issues often cannot.

Overlap with financial due diligence

Some would argue that financial due diligence will provide much of the information and analysis needed to form a view on commercial prospects so why go to the trouble and expense of conducting detailed commercial due diligence? The reason is that financial due diligence tends to be internally focused. It collects its market and competitive information from management. This is one way of reaching an assessment of future prospects. However, by itself it is often not enough. At the very simplest, if management say their products are the most highly rated by all the big customers in the marketplace, due diligence needs to check with those big customers that this is in fact the case - and that it will continue to be the case. In one investigation of a tired UK brand, COD very quickly discovered that all the major supermarkets wanted to stop stocking the product. Those that did so quickly found themselves bombarded with telephone calls from out-at-work actors, hired by the target, expressing disappointment that they could no longer find the product. Faced with this buying interest, the product was quickly given back its shelf space.

On a wider level, understanding the future needs an input from more than one perspective and it needs to be up-to-date which means talking to a wide range of relevant people operating in the market. This, financial due diligence does not do. For example, just because an industry has been price-based in the past does not necessarily mean it will continue that way. Even the construction industry is moving towards a mentality that puts service and just-in-time delivery at least on a par with price. It is only by talking to customers that this trend would be confirmed. Similarly, customers' buying habits have a tendency to change with time. For example, personal computer distributors are now having to change to offer much more than just the traditional supply and install. By getting most of its information from sources outside the target, COD attempts to come to a view of the future by a completely different route.

FDD and COD, then, should be seen as complementary. This complementarity should be recognized by ensuring the two teams work together. Both financial and commercial due diligence teams have access to sources and to information which can be valuable to the other. The financial due diligence team will have access to debtors lists for example. These will contain the identities of ex-customers. For obvious reasons, the CDD team will want to talk to ex-customers. In exchange, the commercial due diligence team can find and provide a wider range of estimates of market size and future growth rates which the financial due diligence team can plug into their forecasts and scenarios.

Com mer cia I due d iii 9 e nee 85


Commercial due diligence does not have to be carried out after Heads of Terms have been negotiated. In many deals, there is a lot to be said for carrying out CDD early on:

1. CDD can confirm or otherwise the buyer's acquisition strategy.

Z. CDD is the least expensive type of investigation to commission from specialist consultants and can provide a clear pre-acquisition stop-go decision before more expensive investigations are started. If there are fundamental problems with a company or its markets, you can save a great deal of time and money by discovering them early.

3. As CDD can be conducted without the knowledge of the target it:

• can avoid raising the seller's expectations

• avoids any embarrassment if the acquisition is not progressed

• allows enquiries to be made without the restraints imposed once confidentiality agreements are signed or by the target's management once a deal is in progress


Commercial due diligence takes three to four weeks. Any more time and the investigation tends to lose focus. It can be done in less time but if it is, there is a risk of not getting to speak to the best contacts and the quality of analysis tends to suffer.

Choosing the team

The choice of who to do the work is perhaps less obvious than it is for legal and financial due diligence. Commercial due diligence is carried out by a bewildering range of organizations and who to use may differ according to the nature and requirements of the acquiring company. The main options are:

• The buyer itself

• The transaction services arms of the big accountancy firms

• A strategy consultancy

• A market research firm

• An industry expert

• A commercial due diligence specialist

Industry experience may also be a consideration, although as argued below, it should not have an overriding influence on who to use.


Many buyers carry out commercial due diligence possibly without recogntzmg it as such. There is usually a lot of knowledge in-house and it is natural during an acquisition to tap this. In other companies the process may be more formal. The major constraint will be the ability to deploy sufficient resources of the right calibre at a moment's notice. However, carrying out

86 Due D iii 9 e n c e

any form of due diligence in-house obviously develops a capability. Frequent acquirers tend to have teams of professionals who build up a great deal of expertise. Some of these companies carry out most or all of the various due diligence procedures in-house. This can be a very cost-effective means of doing the work, It should also, in theory, be pretty easy to maintain confidentiality although that is far from guaranteed. Industries tend not to be leakproof and of course a company making enquiries on its own behalf is not going to be able to maintain anonymity in the same way that a third party could. Finally, operators, as opposed to acquisitions specialists, within buyers tend to become distracted by detail when carrying out this type of work.


Commercial due diligence is an adjunct to the activities of due diligence accountants - and from their poin t of view more I ucra tive than financial due diligence - so it is only natural that they should offer COO as one of their services. They may argue that the financial and commercial due diligence teams will work together more effectively if they are both from the same firm. This is not much of an argument. Outside professionals can work with the accountants just as well as consultants who are members of the same firm. In fact, in large firms internal politics can often inhibit effective internal cooperation and it is not unknown for staff in a large accountancy firm to be just as unfamiliar with the financial due diligence team as outsiders. The downsides of using accountancy-based firms are:

• Their fear of litigation. This means that they have a page and a half of disclaimers to negotiate before they start work and that they may not express opinions unless they have rock-solid evidence to back them up. This can be a bit difficult in a disciplme that relies on analysing and reporting facts and opinions gathered from third parties.

• The accountant's mentality. Accountancy prefers to be precisely wrong than roughly right. A commercial due diligence exercise is all about putting together information from a variety of sources much of which is conflicting or incomplete. Absolute precision, like rock-solid evidence, is a dream.

• Following regulatory pressure, from the American SEC in particular, and high-profile conflicts of interest between audit and advice, audit firms will find it increasingly difficult to continue giving general consultancy advice.

The big advantage they have, although again it might be more apparent than real, is that they have worldwide representation. However, as most commercial due diligence is done by telephone these days worldwide representation probably does not count for so much, especially since their representation outside the Anglo-Saxon markets is likely to be auditbased. Auditors do not generally make good commercial due diligence consultants. Spending a lot of time talking to market participants is not part of their ethos and, in addition, the accountancy firms struggle with the concept of 'platform' based research (1.10'. when you cannot tell the respondent the whole truth about the reasons for your enquiries).


Some of the big strategy firms actually started in CDD and some continue to carry out commercial due diligence work on the bigger deals, especially for financial investors. Like the

Com mer c i al due d iii 9 e n c e 87

audit-based firms, the strategy firms have strength in both breadth and depth. They also bring great rigour to their work, which is something often missing from CDD. Their main drawback is that despite their incredibly talented staff and superbly crafted processes, they may not actually provide a good answer - and they are expensive. Strategy consultancies are best when working on long-term, leading-edge business problems calling for high levels of creative input. CDD is quite different. It is a fastmoving, cut-and-thrust, information-based activity.


In contrast to strategy firms, market research firms do collect information - lots of it - and that is their main drawback. They do not shy away from talking to large numbers of people in the market but they tend to lack analysis and understanding. Even qualitative market researchers will tend to think of information-gathering as their primary focus rather than its synthesis into an answer. Furthermore, The Market Research Society in the UK actually forbids members to contact competitors of clients during projects, arguing that it is unethical. However, if the buyer knows what questions to ask and has the resources to assimilate a lot of data quickly, using market researchers to collect data and opinions may be an entirely reasonable means to an end.


Industry experts claim their knowledge is more pertinent and detailed than that which can be developed by an industry outsider. They also have a shallow learning curve, lots of contacts and should know where to delve for information. There are, however, downsides. Some have been out of the industry for so long that they have lost touch with it. Others may lack necessary skills such as the ability to obtain and analyse information in the context of an acquisition. If industry experts are to be used, it is important to address the issue of confidentiality in detail. The last thing the would-be buyer wants is some industry expert gossi ping wi th contacts and giving the game away.


There are specialists in commercial due diligence. They claim to offer the best of both worlds by combining the research capability of market research firms with the analytical skills of strategy firms. There is considerable truth in this, although on the whole they tend to fall into one of two camps. Some do not have the analytical horsepower of the strategy consultants while others do not have the research horsepower of the market researchers. However, in most cases they will be the most cost effective means of carrying out commercial due diligence.

Industry experience

WiLh commercial due diligence, probably more than anywhere else, the question of relevant previous industry experience crops up as a factor in the choice of supplier. The same argument as mentioned in Chapter 2 applies, namely that the experience required in order of importance is as follows:

88 Due D iii 9 e n c e

1. Experience of carrying out due diligence

2. Experience of the purchaser

3. Experience of the target company's sector

Commercial due diligence is a process which can be applied to industries almost universally. What counts is the skill of the team in carrying out commercial due diligence, not its industry knowledge or industry contacts. Indeed both of the latter have a habit of being irrelevant and out of date. Instead the buyer should look to the commercial due diligence team to bring highly developed information-gathering and analytical skills and a good dose of solid commercial experience. Even in very specialist industries there is a lot to be said for not using industry experts but instead seasoned specialists who know what they are doing and can therefore bring a fresh perspective.

This last point is a theme that crops up time and time again in all areas of due diligence. It is obviously good to have first-class minds working on an acquisition but by their very nature due diligence exercises do not yield perfect information on which to base decisions. There is no substitute, therefore, for having someone on the team who has the hard-bitten commercial experience to know what to look at and who can recognize trouble from 50 metres. For example it is easy for an inexperienced consultant to come to the conclusion that a market has a huge potential simply because the massive installed base is well past its design life and in need of urgent replacement. However, if the buyers are cash-strapped local authorities it is highly unlikely that demand will ever reach its full theoretical potential. Similarly, a potential turn-round in a pretty basic, mature, process industry may have a previous management who lost a lot of opportunities because of their attitude to customers. Customers may confirm this and hint that new management could win extra business. But in a mature industry that business has to be taken from the competition. In a high-fixed cost process industry where products are by and large undifferentiable, competitors' response will be through price. What chances, then, of a turn-found?

It was pointed out in Chapter 2 that senior due diligence advisers will often 'sell' the work then leave more junior members of staff to complete it. This is something to beware of, especially with commercial due diligence. Securing adequate attention from the experienced practitioner is doubly important because there is often a basic division of focus amongst individuals who carry it out. Good commercial due diligence researchers are second to none at finding out just about anything that is required. especially from primary sources. However, they are rarely good at drawing all, and sometimes even the right, conclusions from the firstclass information they collect. This is where the skills of the experienced project leader come in. The leader's role is to stand back from the detail and make sure the research answers the question. Without good, analytical, commercial, project leadership, commercial due diligence exercises too easily degenerate into semi-focused collections of 'interesting' market and competitor information.

Briefing the team

The quality of briefing has a significant impact on the quality of the consultant's report. The reasons for acquiring will, to a large exten t, determine w ha t questions need to be asked. If the acquisition is intended to gain market share, stabilize market prices by knocking out a troublesome competitor or acquire a new growth product then it helps greatly if the CDD